ACCA PAPER F9

FINANCIAL MANAGEMENT LECTURE 3

INVESTMENT APPRAISAL

NPV
Allowing for inflation Allowing for taxation Working Capital

CHAPTER 9

NPV WITH INFLATION

REAL AND MONEY RATES

REAL RATE OR NOMINAL RATE?

If cash flows are expressed in terms of the actual number of dollars that will be received or paid on the various future dates, we use nominal rate for discounting If the cash flows are expressed in terms of the value of the dollar at time 0 (that is, in constant price level terms), we use the real rate.

LECTURE EXAMPLE 1

Rice is considering a project which would cost $5,000 now. The annual benefits, for four years, would be a fixed income of $2,500 a year, plus other savings of $500 a year in year 1, rising by 5% each year because of inflation. Running costs will be $1,000 in the first year, but would increase at 10% each year because of inflating labour costs. The general rate of inflation is expected to be 7.5% and the companys required nominal rate of return is 16%. Is the project worthwhile?

TAXATION

Two tax effects to consider:

Tax payments on operating profits Tax benefit from capital allowances and a possible tax payment from a balancing charge on asset disposal.

 Corporation

tax on profits

Calculate the taxable profits (before capital allowances) and calculate tax at the rate given The effect of taxation will not necessarily occur in the same year as the relevant cash flow that causes it
Capital

allowances Approach
1 Calculate the amount of capital allowance claimed in each year 2 Make sure that you remember the balancing adjustment in the year the asset is sold 3 Calculate the tax saved, noting the timing of tax payments given in the question

 When

dealing with tax in this examination we make the following simplifying assumptions:
tax is calculated on operating cash flows (in practice it is on adjusted operating profits) there is no advance tax payable there is no tax on working capital (either the outflow or the inflow) there is no pool of assets for capital allowance calculations capital allowances are calculated in isolation for the investment in question no other taxes are relevant (e.g. capital gains tax)

WRITING DOWN ALLOWANCES

PRO FORMA NPV CALCULATION

LECTURE EXAMPLE 2
A

company is considering whether or not to purchase an item of machinery costing $40,000 payable immediately. It would have a life of four years, after which it would be sold for $5,000. The machinery would create annual cost savings of $14,000. The company pays tax 1 year in arrears at an annual rate of 30% and can claim tax-allowable depreciation on a 25% reducing balance basis. A balancing allowance is claimed in the final year of operation. The companys cost of capital is 8%. Should the machinery be purchased?

LECTURE EXAMPLE 3
A

company is considering the purchase of an item of equipment, which would earn PBT of $25,000 a year. Depreciation charges would be $20,000 a year for 6 years. Tax-allowable depreciation would be $30,000 a year for the first 4 years. Tax is at 30%. What would be the annual net cash inflows of the project:

For the first 4 years For the fifth and sixth years

WORKING CAPITAL IN NPV QUESTIONS

Working capital is treated as an investment at the start of the project Any increases during the project are treated as a relevant cash outflow At the end of the project the working capital is released an inflow The working capital requirement may be given as a % of (usually) sales

WORKING CAPITAL IN NPV QUESTIONS

If you have a question including both working capital and inflation, you should always adopt the money method (inflating the cash flows). Calculate the actual money amount of the factor on which working capital is dependent (often sales or contribution) before calculating the working capital requirements.

LECTURE EXAMPLE 4
Elsie is considering the manufacture of a new product which would involve the use of both a new machine (costing $50,000) and an existing machine, which cost $80,000 two years ago and has a current net book value of $60,000. There is sufficient capacity on this machine, which has so far been under-used. Annual sales of the product would 5,000 units, selling at $32/unit. Unit costs would be as follows: Direct Labour 8 Direct materials 7 Fixed costs (inc dep) 9 The project would have a five year life, after which the new machine would have a net residual value of $10,000. Because direct labour is continually in short supply, labour resources would have to be diverted from from other work which currently

earns a contribution of $1.50 per direct labour hour. The fixed overhead absorption rate would be $2.25 an hour ($9/unit) but actual expenditure on fixed overhead would not alter.
Working capital requirements would be $10,000 in the first year, rising to $15,000 in the 2nd year and remaining at this level until the end of the project, when it will all be recovered. The companys cost of capital is 20%. Ignore taxation & inflation. Is the project worthwhile?

DEALING WITH QUESTIONS WITH BOTH TAX AND INFLATION

Combining tax and inflation in the same question does not make it any more difficult than keeping them separate. Questions with both tax and inflation are best tackled using the money method. Inflate costs and revenues, where necessary, before determining their tax implications. Ensure that the cost and disposal values have been inflated (if necessary) before calculating WDAs. Always calculate working capital on these inflated figures, unless given. Use a posttax money discount rate.

SUMMARY

An exam standard NPV will have to deal with tax, working capital and inflation. Tax Follow the rules given by the examiner to work out the timing and the amount of tax paid on the projects cash flows and the tax saved on capital allowances Working capital Work out the changes in working capital, these become the cash flows for the NPV dont forget to run working capital down to zero in the final year. Inflation If there is 1 rate of inflation ignore inflation (use real cash flows and the real cost of capital) If there is more than 1 rate of inflation - include inflation (use nominal cash flows and a nominal cost of capital).