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Dear Sir,
I should be glad if you can help explain why the examiner treated ‘tax allowable depreciation’ (TAD) the way he did in the answer.
1. firstly it is a bit confusing when he uses ‘depreciation’ in the financial extracts, and uses ‘tax allowable depreciation’ in the notes. Is he referring to the same thing in this case?
2. The answer uses ‘PBDIT’ as the starting point of the calculation of free cash flows. This excludes Depreciation/TAD. As a result I do not see a net off effect between CAPEX and Depreciation/TAD. I see myself bringing in CAPEX and ignoring depreciation/TAD as it is not part of PBDIT in the first place.
3. My understanding regarding the TAD (non-cash) is that it is brought in for the purpose of calculating tax (cash flow). Should the TAD not be added back to free cash flow afterwards?
Please help
Regards
Samson
1. It is normal. Financial accounting depreciation is not necessarily the same as the tax allowable depreciation (i.e. capital allowances). It is the tax allowable depreciation that is relevant for DCF calculations.
2. The taxable profit is the profit after subtracting the tax allowable depreciation – this is Paper F6
3. Tax allowable depreciation is only added back if it had been subtracted in the first place in arriving at the cash flows. In the answer to this question it is not the case. They have shown the cash flows before the capital allowances and shown the actual tax payable.
Dear John,
Thank you for your reply. However, I am still a bit unclear.
Basically the confusion surrounds the treatment of these three:Depreciation
Tax Allowable Depreciation(TAD)
Investment-Capital Exp.For the purpose of calculating taxable profit, and therefore, tax (a cash flow), I understand the TAD will be subtracted from profits.
If we are unable to add back TAD to after tax profits, It is difficult to see the net-off with the CAPEX.
In that case which item has been netted-off with the CAPEX, because in the answer the CAPEX did not form part of the calculation of free cash flows.
Kind regards
Samson
The capital expenditure only occurs when the assets are bought and is not relevant in Vogel because the assets already exist.
The tax allowable depreciation is not a cash flow, but allows you to reduce the taxable profit and therefore pay less tax.
I don’t know what you mean by ‘net off with the CAPEX’. We do not net the tax allowable depreciation/capital allowances off against the expenditure. They exist simply to reduce the tax payable.
Dear John,
Thanks again for your time and support.
I am talking about net off because of the below reply you gave to a participant in the past.the participant wanted to know why the tax allowable depreciation was deducted in calculating taxable profits, but not added back to free cash flow. You explained that the investment was equal to the depreciation, so there is no point in adding and subtracting the same figure twice.
The answer deducts TAD in arriving at taxable profits, then deducts tax to arrive at free cash flow. I expected to see TAD added back to free cash flows, but this was not the case.
In your first reply you said the TAD was not deducted to arrive at the cash flows. That is the case in the question, but not so in the answer.So is it not the case that if we did not have to add back the TAD (though it was deducted initially in the answer to calculate taxable profits and subsequently free cash flows), then there is no cancelling effect between the investment required and TAD to warrant us ignoring them completely from the answer? It would seem that TAD would have been added back to free cash flow if not for the assumption of equality with the investment required.
Kind regards
.November 30, 2014 at 11:18 am
avatar
lzyjzy
Participant
When estimating FCFF for division B spinoff, depreciation is deducted from FCF to arrive at taxable profits. But depreciation is not added back subsequently even though it is not a cash flow – doesn’t this underestimate Vogel’s CF by the tax allowable depreciation amount?
Thanks!
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| Quote Reply November 30, 2014 at 3:21 pmProfile photo of John Moffat
John Moffat
Keymaster
It is because the amount needed to maintain the assets (which is a cash flow) is assumed to be the same as the depreciation figure.
Sorry – I misunderstood your original question.
The depreciation has been subtracted in order to calculate the tax, which you are happy with.
However the depreciation is not a cash flow and therefore we would then usually add it back to the profit after tax in order to get the cash flow.
But note (vi) of the question says that they need an investment equal to the depreciation in order to maintain operations – therefore there is a cash outflow equal to the amount of the depreciation.
Rather than add back the depreciation and then subtract an equal amount (which would be correct) , it is more sensible just to ignore it completely.There is no further tax effect on the amount needed to maintain operations.
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