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Hello guys. Please am confused as to when exactly we shouldn’t recoup working capital at the end of the project life. Should we ignore recovering of working capital only when we are told not to? What’s the criteria please.
You always recover working capital at the end of the project unless:
1. The question says to ignore the recover of working capital (as it has done on one occasion)
or
2. If the question makes it clear that the product will continue to be produced (and therefore the machine replaced and the working capital will still be needed) – this has happened in one other question.
Thank you John, I have also thought so too. However I got confused when I saw a question in Bpp kit Page 37 called BRT Co.
In this question , the production/sales will continue after the fourth year. However working capital was recovered in the fourth year as seen in the solution to the question on page 140. The working capital of 820 was recouped in year 4. Any reason for this?
It is a past exam question, and the examiner used to always automatically recover the working capital.
More recently he has followed the ‘rule’ that I wrote above.Don’t worry too much – he has said for his more recent questions that you would still get the marks if you recovered the working capital.
Thank you so much John. That really cleared my confusion.
I have another question on Lease or Buy Decisions as seen in Page 41 Bpp revision kit (Asop Co), solutions on page 154.
In determining whether to lease or buy (“a” part of the question), the Net cash flows were discounted using the aftertax cost of debt of 6%. I can understand why the 6% rate is used for discounting net cash flows from purchasing the asset (because the question says the purchase will be financed by a loan paying interest of 8.6% before tax.
However I don’t seem to understand why the same 6% rate is used to discount to net cash flows from leasing the asset. Does that means the lessor also demands the same 6% interest rate like the loan financing?
Also the “b” part of the question asks us to determine the NPV of buying the new technology. The Net cash flows here were discounted using the weighted average cost of capital of 11%. Why is this the case? I expect that since the purchase will be financed by a loan with an after tax rate of 6%, then it should also be discounted with the 6% rate (reflecting the specific interest payment on taking up the $1m dollar loan) and not the WACC.
Finally , why is tax savings on license fee not considered in this same part b.
Thanks
In future, please ask in the Ask the Tutor Forum if you want me to answer – this forum is for students to help each other.
Also, please start a new thread when it is a new topic (this is obviously not about working capital 🙂 )
When deciding on the method of finance, leasing involves the lease payments whereas borrowing and buying involved repaying the borrowing at 6%. To decide which is cheaper we always discount at the cost of borrowing.
In part (b) we are deciding whether or not the project is worthwhile (we have already made the financing decision) and as always for this we discount at the WACC.
(I do suggest that you watch my free lectures on lease and buy because this is explained. Our free lectures are a complete course for Paper F9 and cover everything needed to be able to pass the exam well).
With regard to the license fee in part (b), the tax has been calculated after subtracting the licence fee – so they are making a tax saving from it.
Wow that’s an amazing answer, thank you so much. And yes I will use the Ask the tutor forum next time I wanna ask you. Thank you ?
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