- This topic has 11 replies, 4 voices, and was last updated 8 years ago by
.
- Posts
Dear Sir,
I have three questions in relation to APV calculation in Neptune 06/08. Thank you in advance for your time. Please let me know if you need further clarification.
1. When calculating the cost of ungeared equity, I decided to use CAPM model to calculate cost of geared equity (based on company’s equity beta, risk free rate and risk premium), and then using M&M proposition to calculate the cost of ungeared equity. I know It is not as straightforward as using Asset Beta Formulae, but I felt the process was justifiable. The Ke is 9.4% as opposed to 8.97% in the model answer. I wonder what is likely the issue with this approach, could I get mark if I do it this way in the exam?
2. I have included indirect activity based costs in cash flow calculation. Could you please explain why it wasn’t relevant in arriving at taxable profit?
3. Depreciation (accounting value) and Capital Allowance (tax value). When these two combined together, in practice it gives rise to deferred tax liability/assets when the underlying asset is settled. Maybe I was over-thinking too much, but could you explain the way it was treated in the model answer? I.e. no deferred tax at all.
Thanks!
Dear Sir,
I would like to add 3 further questions. Neptune is quite different from rest of the APV questions I have practiced so far, probably due to the lagging tax effect (payable one year in arrears). This really confuses me.
4. This is again another question about capital allowance. Let’s look at 20X9 for example, profit before capital allowance is $122mil. Normally, one will then deduct depreciation/capital allowance to arrive at the taxable profit (of course add it back after tax calculation to reflect the real cash flow). In this case, the WDA is $160mil, which means the total taxable profit is now a loss ($38mil)! In other words, Neptune in theory should pay zero tax in this year.
Pilot Paper Tramont stated very clearly tax treatment methods in the event of loss, but what are the assumptions behind this question?
5. In the question, it is said “The new issue will incur transaction cost of 2% of the issue value at the time of issue”. I presumed it means 2% issue cost, but the model answer suggests the total loan value needs to be increased by 2%, and annual interest shield should be 800x(100/98)x7.2%x30%. This is a very different treatment from other questions, where consistently they use the original loan amount (not issue cost inflated) to calculate tax shield. Please explain.
6. The tax credit/charge will be received/paid one year in arrears. When comes to calculation of tax shield, shouldn’t the right time value adjustment be (annuity @ 7.2% for 6 years – discount factor @ 7.2% at Year 1), instead of annuity for 5 years?
Thanks again for your help!
1. It is fine to use the M&M formula to get the unguarded cost of equity and it should have given the same answer (the asset beta formula is in fact arrived at using the M&M formula).
I can only guess something went wrong in the arithmetic in which case it would only have cost you half a mark – the idea is fine.2. The fact that the overheads had been arrived at using an ABC approach suggests that the total overheads for the company are not changed as a result of doing the project – just that they are absorbed differently. We are only concerned with any additional costs as a result of doing the project.
3. Deferred tax is an accounting concept and is not relevant for investment appraisal. All we are interested in is the actual cash flows and the timing of them i.e. the actual tax payments and their timing.
4. The question says that the company has sufficient other profits to absorb capital allowances and therefore there is no question of there being a tax loss. The fact that this project makes a ‘loss’ simply reduces the taxable profit of the company as a whole and therefore saves the company tax. This is the standard assumption for both F9 and P4, even if the question had not included that line.
5. The question says that the transaction costs will be 2% of the issue value, so for every $100 raised, only $98 is available for investment and therefore the interest payable will be on the full $100. This is a fairly standard ‘trick’ which has been relevant in several questions.
6. Yes. Strictly what you have written would be more accurate and the discount factor should be the 6 year annuity factor minus the 1 year factor (or alternatively, the 5 year annuity factor multiplied by the 1 year factor, which would give the same result).
Hi John, thanks a lot for your fair explanation and extremely quick response!
Your comments perfectly answer all my questions, far exceeding my expectation 🙂
Dear sir, with regards to MIRR calculation, y have they taken 6 yrs instead of 5 yrs in the formula? Since the project is for 5 yrs….is it dat tax is in arears therefore they have taken 6 yrs? Thank u
1-The issue cost seem to me treated differently in the this question(Neptune) and Burung co(6/14)
I mean what is the correct way of dealing the issue cost, either tax rate is applied to issue cost or not for calculating the total benefits, what is the correct way?
If we see the answer in the BBP kit issue cost are treat differently in both, in Burung co no tax rate is applied and in Neptune the P.V of tax shield do not match(67.06) unless we applied the tax rate of 30% to issue cost and deduct it from the debt benefit amount which is $71.8m2-Secondly how to we know that issue cost is included in the debt amount like in Burung, or not?. Hope my question is clear
3-kindly see the capital allowance calculations in Neptune , there is 7 years, instead of 6, why this is so
4-I have practiced almost 8-10 questions(25) which is almost 50% of investment appraisal(25makrs) and every question i practiced looks much different to me, and i was not able to solve it properly, and in result my confidence is shacking so much that i am making silly mistakes, how to deal with it?
Sorry – I must have missed your question somehow yesterday.
1. The tax benefit never relates directly to the issue costs – it is always calculated on the interest on the amount borrowed.
In both questions the issue costs have been calculated (correctly) as 2/98 times the amount required for the investment.
However, in Neptune the examiner assumed that the amount actually borrowed was higher than the amount needed for the project (in order to cover the issue costs) whereas in Burung, the examiner has not added them on and has therefore only calculated the interest on the amount used for the project.
I would have done the same as for Neptune, and would still have got full marks (even though obviously the final answer is different).
Do appreciate that (as in real life) so much of P4 (certainly the question 1’s) depends on assumptions, and provided you state your assumptions you will still get the marks. There is rarely only one correct answer. That is why almost always the question specifically asks you to start your assumptions.With regard to the capital allowances in Neptune. Although the answer shows 7 calculations they only result in figures for 6 years (20X9 to 20Y4). More sensible in 20Y4 you would not calculate WDA and then the balancing charge. Instead just subtract the residual value from the tax WDV at the end of 20Y3 and you end up with exactly the same net figure for 20Y4 (a net saving of 3.5)
With regard to your final comment. Firstly, as I wrote before, in P4 there is rarely one correct answer – it depends so much on assumptions, and you must state your assumptions. Secondly, nobody is going to get questions completely correct – it is a hard exam – but the marks are for the approach rather than the exact figures. Provided you set out your workings neatly in a way that the marker can follow, then if you are proving that you basically understand what you are doing you will get most of the marks.
It is obviously question 1 that is the most important and what you might find useful is that I have recorded a few lectures working through some past Question 1’s where in addition to working through the technical content I also talk about how to approach the questions.
You can find them linked from the main P4 page – “P4 Revision and Past Questions”.
- You must be logged in to reply to this topic.