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Dear sir,
Please help me to explain what they’ve done in the working of free cash flows of Ndege Co (spun off from Department B):
***
Free cash flow of Ndege Co $ million
Current share of PBDIT (0·4 x $37·4m) 14·96
Less: attributable to Department C (10%) (1·50)
Less: tax allowable depreciation (0·4 x 98·2 x 0·10) (3·93)
–––––
Profits before tax 9·53
Tax (20%) (1·91)
–––––
Free cash flows 7·62*****
I’ve learnt that the depreciation does have a tax shield, which is added back after calculating profit after tax. So why are they subtracting the tax allowable depreciation instead of adding it back? Or am I missing something here?Thanks a lot!!
sorry sir, I tried to format the numbers into a column before submitting but it seems that all the spaces disappeared.
Firstly, the only reason we usually add back depreciation is because we subtracted it earlier in order to calculate the tax (and then add it back after because it is not a cash flow).
Here it has been subtracted in order to work out the tax.
The reason it is not added back is because note (vi) in the question says “It can be assumed that the amount of tax allowable depreciation is the same as the investment needed to maintain Ndege Co’s operations”, so there is no point in adding back the depreciation and then subtracting the same amount as new investment.
The current examiner does this very often.
so the number subtracted (3.93) is actually the investment to maintain operation of Ndege Co, isn’t it? This point makes me so confused.
Yes it is.
(Strictly I suppose that after calculating the tax you should then add back the depreciation (because it is not a cash flow) and then subtract the same amount (because the new investment is a cash outflow). However the examiner does not expect you do bother doing that – doing neither has the same net effect 🙂 )
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