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Hi John,
Can you please help me.
I’ve watched your lecture and read your notes on sensitivity analysis and thought I was clear on it but when looking at the question ‘Warden Co’ Dec ’11 paper i don’t understand how they’ve worked out both the selling price sensitivity or discount rate sensitivity.
Selling price. Why is the tax worked out as 30% but only one year discounted for pv of tax liability? Wouldn’t five years tax be discounted?With regards to the second part of question – discount rate sensitivity. I thought I was suppose to do an IRR calc. Which I got 15% as IRR. I don’t understand were the 16 has come from? 11 is the discount factor?
Apologies if the above are ridiculous questions.
Thanks in advance
CatrinWith regard to the selling price, you could have got the same result two ways. You should either have found the PV of 5 years of revenue (1 to 5) and 5 years of tax on revenue (2 to 6, because of the one year delay). Alternatively you can calculate the PV of 5 years of revenue (1 to 5) and then take 30% of that PV and discounted by 1 year to account for the 1 year delay.
If you think about it, both ways are effectively doing the same thing and will give the same final result.With regard to the second part, yes – you need to calculate the IRR and the answer has done this (by making 2 “guesses” as normal when calculating IRR). From part (a) we already know the NPV at 11%. The answer has made a second guess at 17% (but as the answer says, any second guess would have done), and then done the normal IRR calculation to arrive at an IRR of 16%.
Thanks John.
I think i understand. I find the way they’ve layed the answer out for the question a bit confusing. I understand the revenue part but I was trying to work out the tax pv as 102,000 x 5 x 4.231 = 2157810 less 102,000 x 0.901 = 91902. Which is way off. Still not sure why that doesn’t work butI’ll try and remember the format in the book.
Yes, got 16% for IRR.
Thank you!Because we are looking at the sensitivity of the revenue, we need the tax on the revenue only (the tax affect of everything else will not change).
The tax on the revenue is 30% x 1,600 = 480 per year, for years 2 to 6.
If you want to discount it separately, then no problem.
To discount for years 2 to 6 you take the annuity factor for 6 years and subtract the factor for 1 year. This gives 4.231 – 0.901 = 3.330.
If you multiply 480 by 3.330 you get 1598.4, which is the same as the answer.Hi john, this is my first question in this website. Will be glad if you answer it. i also have a little problem with the same question. Can you please tell me why do we actually exclude/tax from the revenue in sensitivity margin calculation? I want to know the reason behind it. This same question has a post tax cost of capital (11%) is there any relation with that?
Thanks in advance.John sir, Also please tell me if there would have been any such tax effect in the calculation of sensitivity margin of variable cost/ fixed cost/ sales volume or any other variable.
Let me give you a little example.
Suppose revenue is 100, expenses are 80, and tax is 30%.
The net cash flow before tax is 20 and the tax is 6 giving a final cash flow of 14.Suppose now that the revenue increases by 10%.
The revenue goes up to 110. So the net cash flow is 30. Therefore the tax is now 9. This gives a final cash flow of 21.This is higher than before by 7. Why is it 7? It is because the revenue increased by 10, but as a result the tax increases by 30% x 10 = 3. So the overall effect is an increase of 10 – 3 = 7.
Hope that helps.
Thank you so much sir for such a quick response. The calculation of sensitivity margin for other variables such as variable cost, fixed cost, sales volume will have no change due to tax right?
Yes they will.
Make up a little example again – if variable costs increase then profit will reduce and therefore the tax will reduce. The net effect will be the amount of the after-tax variable costs.
it’s really confusing me, i can understand somehow why present value of tax has been deducted from the calculation of present value of sales. What i understood is that: as the project npv (numerator) has the tax effect so it’s effect on present value of sales (denominator-present value of factor under consideration) should also be accounted for. Now if we were asked to calculate sensitivity margin of variable cost, what would have been done?
Tax% x pv of variable cost = a number.
Discount it using pv table and then add this figure to the present value of variable cost ? I.e. same as for sales but here we subtract and for sales we deduct? Am i right in these steps?
Actually there’s no such example in the kit or past papers that’s why it’s confusing.
Thanks in advanceI think you might mean right, but you have written it wrong.
Suppose the variable cost is 100 a year.
Then if tax is 30% the tax being saved because of this cost is 30 a year (if the cost wasn’t there the profit would be higher and therefore the tax bill would be higher).So the net effect of the variable cost is 100 – 30 = 70. You would then discount this in the normal way, and then the sensivity will be NPV / the PV of the 70 a year.
Sorry sir for disturbing you so much. Just need to summarize now. I jave exam om Friday 🙁
we deduct the pv tax effect from the pv variable under consideration to find sensitivity margin. Am i right if i consider it in the following way:
Variable could be-> selling price, variable cost, fixed cost.
Suppose the pv amount is 100 for each of the variable, in calculating present value of a specific variable (denominator) we will deduct pv of tax 30 from them. Right?Now if we were to calculate sensitivity margin for sales volume, we divide npv with pv of contribution. Suppose If contribution pv is also 100 then again we’ll like above deduct pv of 30 tax from it right? Same rules apply?
Will wait for your response.. Just need to know if the methodology is correct.Referring to my previous message: Chapter 6 of kaplan (investment appraisal under uncertainty) has a test your understanding (1), where sensitivity of initial investment, selling price per unit, variable cost, sales volume, fixed cost and discount rate is to be calculated. Want to figure out how would the answer change if there was a tax of 30%.
According to your past reply, pv of tax on the sales should be deducted from the pv of sales and then used as denominator. And similarly pv of tax on the variable cost should be deducted from pv of variable cost and then using it as denominator.
So i am assumung that it’ll be same for fixed cost too as it’s a a cost like v cost.
Need to know if for sales unit it’ll be as i stated in my previous inquiry or not.Yes – it would be the same for fixed costs as for variable costs.
For sales units it will be the contribution less tax on it, because both sales and variable costs are affected.
Finally understood after taking so much of your effort 🙂
So,
No change in the sensitivity margin calculation of scrap value & initial investment as tax doesn’t effect them right?
And for discount rate sensitivity also, no change.. Simply based on IRR.
Am i correct in all these?
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