Neptune (june 2008 question)

1. I assume that you are happy with the opportunity cost of $150M itself. Why the examiner called it redeployment of labour, I have no idea (that is just one possible reason for it happening). What you call it is irrelevant in the exam – I would simply call it lost contribution.

2. This question was set by the previous examiner, and it was obvious from a few of his answers that he did not understand tax so well! The capital allowance benefits should have started one year later. (Also, he has calculated writing down allowance in the final year and shown tax on proceeds – although the end result would be the same, there should not be WDA and tax on proceeds, it should be a balancing charge)

I know that might sound worrying, but the markers for P4 are very good and know the subject. They would pick this up in the marking and it would be discussed and full marks would be given to those who did it correctly.
The current examiner does seem to understand how tax works 🙂

It would certainly be wrong to ignore it.

Whatever the description, the question specifically says that acceptance of the project will mean that other work will not be able to proceed and therefore doing this project will lose 150M for each of the two years that would otherwise have been earned – i.e. an opportunity cost.

We only add back the capital allowances if they had previously been subtracted.

Here they have not been. The answer has calculated the tax on the operating cash flows (without any depreciation having been subtracted) and then shows the tax saved on the capital allowances.

So there are no ‘non-cash’ flows and so nothing to be added back.

I think your problem has arisen because the question had a rather ridiculous bit of working in it that strictly is wrong. (This was the previous examiner and he didn’t seem to really understand how tax works. Fortunately the current examiner does understand and so the problem does not these days arise 🙂 I do explain this in my very first reply to this thread!)

The question said that the charges are “12 months after they arise”.
As a result he has charged the first tax on the profits before allowances at time 2, and he has had the first capital allowances at time 1.
This is not what should happen. The first profits are indeed taxed at time 2, but as far as the capital allowances are concerned, since the investment was on 1 July 2008 (time 0), the allowances are calculated at 30 June 2009 (time 1) and the tax affect occurs one year later at 30 June 2010 (time 2).

Although the answer strictly follows the instructions, the instructions are not what happens in practice (or in current exam questions).

Doing it the correct way, then the two approaches give the following at time 1 and time 2

Doing it the examiners way:

Operating cash flow……………….122 …………… 210
Tax on operating flow…………….. – ……………. (36) (tax on time 1 with a 1 year delay)
Saving on CA’s…………………….. – ……………. 120. (on time 1 TAD’s with a 1 year delay)

Net cash flow………………………..122 …………….. 294

Doing it your way:

Operating cash flow………………122…………………210
CA’s…………………………………..(400)………………(160)

Taxable profit………………………(278)………………..50
Tax (1 year later)………………….. – ………………….83 (30% x 278)

Add back CA’s…………………….400………………..160

Net cash flow………………………122………………. 293 (the difference of 1 is rounding and is irrelevant)

Both approaches will give the same result except in one situation. In Paper FM (was F9) new investments were in the same country and we always assumed the company was making plenty of profit elsewhere. So a loss on the new investment simply results in a reduction in the companies profit and therefore a tax saving.

In Paper AFM, the new investment is often in a different country, in which case a loss does not reduce existing profits for tax purposes but results in loss relief – no tax in the year of the loss, but then the loss reduces the taxable profits in the following year.

Because investing abroad is very common in Paper AFM it is safer to use the examiners way (even though this particular question was stupid for the reasons I have explained).

You are welcome 🙂