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I have the following 3 queries:
1.Why is interest paid not deducted when arriving at cash flows and tax is then calculated on PBIT.
2.In past ACCA exam questions why is the tax shield on tax allowable depreciation not added back to arrive at the cash flows.
3.In the question if it is mentioned that the depreciation is exactly equal to the additional investment needed do we then need to add back the depreciation to arrive at the cash flows if yes or no why.In answer to your questions:
1. When we discount, we are accounting for the after-tax cost of capital. The cost of capital is calculated including the after-tax cost of debt. To include the interest (and the tax saving on it) in the cash flows would effectively be ‘double-counting’)
2. The tax saving on capital allowances (tax allowable depreciation) is taken into account in all questions. What may be confusing you is that there are two ways of dealing with it. You can either calculate the profit after depreciation, calculate the tax on this figure, and then add back the depreciation because it is not a cash flow. Alternatively, (and generally easier) you can calculate the tax on the profits before depreciation, and then separately calculate the tax saving that results from the depreciation. Both approaches give the same final answer, but the second approach is again generally easier.
(Incidentally, don’t call it tax shield. The phrase ‘tax shield’ is used to describe the tax benefit associated with using debt finance (the tax saving on the interest).)3. On its own, depreciation is not a cash flow and is therefore added back. However, extra investment results in a cash outflow. So if the two figures are the same, then there is no net effect and both can effectively be ignored.
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