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hi Sir,
1.I do not understand that why we deducted the tax allowable depreciation and then added it back in base case npv?
2.In part b i dont get the last point of the following paragraph:
There may also be incumbent managers who have large amounts of their wealth invested in Trosoft. If these managers diversify, they will reduce their exposure to total risk. This opens up other arguments as to whether these managers are acting in the best interests of the other shareholders, if the other shareholders
do hold well-diversified portfolios of other shares.
Thank you in advance1. Tax allowable depreciation is subtracted in order to arrive at the taxable profit and therefore the tax payable. It is then added back because the depreciation itself is not a tax flow.
(The alternative – which gives exactly the same result – is to calculated the tax on the operating cash flow and then calculate the tax saving as a result of the capital allowances.)
The free lectures on NPV will help you understand – including the lectures for Paper F9 on dealing with tax, because it is the same in P4 as for F9)2. If shareholders are well-diversified then there is no benefit to further diversification (because the unsystematic risk will already have been diversified away). So in the situation described, the managers could be making decisions that are in their own interests but are not in the interests of the other shareholders.
(The free lectures on portfolio theory and capital asset pricing model deal with the issue of diversification)Sir,
1) item (f) in this question says that “The company has other profitable projects”. Is that is why we utulise tax on loss in year 0 in amount of 289, and year 1 and 2?
2) Normally Year 0 is NOW point of time and period from 0 to 1 is a first year. However in that question we account for expenses and taxes in Y0. How could it be? All the Cash flows occured during first year should be accounted in Year 1 not in year 0. Should we treat these expenses in the same way as Investments which normally occur in year 0?
3) Why do not we account for depretiation starting from Y0 then?
Thank you in advance!)
Sir,
one more question:
– the examiner calculated issue costs as 3100*1,5%=46,5
– but normally issue costs are calculated as 3100/0,95*1,5%=47,2Can I use the second method in all questions?
1. If there are other profitable projects (which is what we usually assume anyway) then the company is not making a loss. Doing this project will reduce the overall profit in the early years and therefore create a tax saving.
2. I don’t know which edition of the BPP kit you are using, but I am using the current edition in which all the revenue and expenses start from time 1 (except for marketing and royalties – they are presumably payable in advance because of the original draft proposal in the question).
3. See (2)
Your second question.
No – it depends on the wording in the question.
In this question it says that ‘all other year 0 outlays will be financed from existing cash flows’ and therefore presumably the issue costs are financed from existing cash flows and not from the debt raised.
However it is a tiny point and sometimes the wording is not perfectly clear. If you state what you have assumed then you will usually get the marks anyway.
But if we make an advance payment for expenses (purchases) it is not an expense itself, it is an advance payment which is not accounted for tax purposes. But we account for tax purposes anyway in Y0 in that question. It is also difficult to assume that the company is on a cash basis accounting because large companies are normally have accrual based accounting system. May be it is a bit unfair part of the question? Not sure how to interpret it properly…
What should my strategy for Y0 expences to be for all other questions? To ignore all the staff I mentioned above and account for tax purposes for any expences appear in Y0? When do you mean the advance payment was made at point Y0?
P4 questions require so many tiny bits to capture and interpret properly… Need to practice a lot before an exam…
If (for example) you pay royalty of 100 a year and you pay it at the start of the year, then it is an expense for the year and will therefore affect the tax. If the cash flow occurs at the start of the year, then the cash outflow is at time 0. If the cash flow occurs at the end of the year then it is a cash outflow at time 0.
It is nothing to do with cash based or accrual based accounting. DCF is based on the cash flows and the timing of those cash flows,
We always assume that operating cash flows (i.e. revenue and running expenses) occur at the ends of years unless told differently.
“If the cash flow occurs at the end of the year then it is a cash outflow at time 0”. – Do you mean at year 1?
“It is nothing to do with cash based or accrual based accounting. DCF is based on the cash flows and the timing of those cash flows” – That is right, but tax is calculated based on expenses and revenues which are recognized based on accrual method.
I have to remember that if I see expenses occurred on Y0 I need to account for tax on them otherwise it is becoming exaggerating…Thank you!!! All the other parts regarding this question became absolutely clear to me!!))
I am really sorry – I mistyped. Yes – if the flow is at the end of the year, then it is at time 1.
The tax (usually) is calculated at the end of the year (for all revenue and expenses during the year). If tax is payable immediately then the tax for the first year is paid at time 1. If tax is payable with a 1 year delay then it is paid at time 2.
If it is not made clear in the question, then simply state your assumption and work on that basis. (A lot of certainly Q1 depends on the assumptions you make, which is why almost always the question tells you to state your assumptions. Provided your assumptions are reasonable (and your figures are correct based on your assumptions) then you get the marks – even if the examiners answer makes different assumptions 🙂 )
Sir,
Why is it that after year 4, head office overhead were only increased by inflation rate of 2% (year 5=66, year 6=68) instead of $5000 + 2% ( year 5= 70, year 2= 65)?
Thank you.
Because note (o) of the questions says that all costs (except royalty) will stay constant in real terms. Therefore the will only increase by the rate of inflation of 2% and no longer increase by $5000 a year as well.
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