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Q. Victory Co is considering the purchase of new equipment which would enable the company
to expand its operations. The equipment will cost $1.2 million and have a three?year life, at
the end of which it will have a scrap value of $600,000.
The equipment will mean Victory requires further factory space at an annual rental of
$80,000, payable in advance, with the first payment being made on the day the equipment
is purchased.
Further annual fixed costs charged to the project will be $715,000 in total. Amongst other
things, this includes:
? $86,000 of bank interest payable on the loan to cover the cost of the equipment.
? $74,000 of costs allocated out of head office overheads.
? A depreciation charge for the new machinery that has been calculated using the
straight?line method over the life of the machine.
Additional annual sales are expected to be 60,000 units per annum in each of the three
years. Each unit will sell for $40 and has a variable production cost of $25.
A further investment of $340,000 will be required for working capital. This will need to be
in place at the start of the year. This will increase to $400,000 in the following year and
$450,000 in the year after that. This working capital investment will be fully recovered at
the end of the project.
If Victory Co buys the new equipment it can claim tax?allowable depreciation on the
investment on a 25% reducing balance basis. The company pays taxation in the year to
which it relates at an annual rate of 30%. Victory Co uses a cost of capital of 10% per
annum for appraising its investments.
Ans:Sales (60,000 × $40) 2,400 2,400 2,400
Variable costs (60,000 × $25) (1,500) (1,500) (1,500)
Fixed costs (W1) (355) (355) (355)
Rent (80) (80) (80)Net operating cash flows (80) 465 465 545
Tax (140) (140) (140)sir, in the answer sheet there is
(The timing of the tax cash flows must be carefully considered. Although the first rent
outflow of $80k is showing at T0, the tax effect of this i.e a $24k tax saving appears at
T1 and will continue for the next 3 years, until T3.)why is tax 140 in all 3 year ?
It is difficult for me to answer fully without seeing the whole of the answer – you have clearly only typed part of it.
It would appear that they have dealt with tax in the way that I do in my free lectures (which is the easiest way).
They have calculated the operating profits (465 per year, which presumably you are happy with).
Then they show the tax on the operating profits (465 x 30% = 139.5, rounded up to 140 per year).What you have not typed is that they will then continue and the tax saving as a result of the capital allowances, before calculated the total net cash flow each year.
I really do suggest that you watch my free lectures on investment appraisal with tax where I work through an example explaining in detail how we deal with the tax.
(Our free lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well.)
Hi John,
The taxable cash flow for year 3 is 545. From what I understand, the 30% tax would be applicable to the year it relates to which means tax in year 3 should be 163.5 (545*0.3). Why is it 140 in the answer?
Thanks,
Maria
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