ACCA F9 Lecture 3

7/27/2019 ACCA F9 Lecture 3

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ACCA PAPER F9FINANCIAL MANAGEMENT

LECTURE 3



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 actualnumber of dollars that will be received or paid onthe various future dates, we use nominal rate for discounting

If the cash flows are expressed in terms of thevalue of the dollar at time 0 (that is, in constantprice level terms), we use the real rate.



LECTURE EXAMPLE 1

Rice is considering a project which would cost $5,000now. The annual benefits, for four years, would be a fixedincome of $2,500 a year, plus other savings of $500 ayear in year 1, rising by 5% each year because of

inflation. Running costs will be $1,000 in the first year, butwould increase at 10% each year because of inflatinglabour costs. The general rate of inflation is expected tobe 7.5% and the company’s required nominal rate of return is 16%. Is the project worthwhile?



T AXATION

Two tax effects to consider:

Tax payments on operating profits

Tax benefit from capital allowances and a possible taxpayment 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 sameyear as the relevant cash flow that causes it

Capital allowances

Approach

1 Calculate the amount of capital allowance claimedin each year

2 Make sure that you remember the balancing

adjustment in the year the asset is sold3 Calculate the tax saved, noting the timing of taxpayments given in the question



When dealing with tax in this examination wemake 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 theinflow)

there is no ‘pool’ of assets for capital allowance calculations – capital allowances are calculated in isolation for theinvestment 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 topurchase an item of machinery costing $40,000payable 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 annualrate of 30% and can claim tax-allowable depreciation

on a 25% reducing balance basis. A balancingallowance is claimed in the final year of operation.The company’s cost of capital is 8%. Should themachinery be purchased?



LECTURE EXAMPLE 3

A company is considering the purchase of anitem of equipment, which would earn PBT of $25,000 a year. Depreciation charges would be$20,000 a year for 6 years. Tax-allowabledepreciation would be $30,000 a year for the first4 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 thestart of the project

Any increases during the project are treated as arelevant 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 workingcapital and inflation, you should always adopt themoney method (inflating the cash flows). Calculatethe actual money amount of the factor on which

working capital is dependent (often sales or contribution) before calculating the working capitalrequirements.



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 andhas a current net book value of $60,000. There is sufficientcapacity 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 newmachine would have a net residual value of $10,000. Becausedirect labour is continually in short supply, labour resourceswould 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 onfixed overhead would not alter.

Working capital requirements would be $10,000 inthe first year, rising to $15,000 in the 2nd year andremaining at this level until the end of the project,when it will all be recovered. The company’s cost

of capital is 20%. Ignore taxation & inflation.

Is the project worthwhile?



DEALING WITH QUESTIONS WITHBOTH TAX AND INFLATION

Combining tax and inflation in the same question doesnot make it any more difficult than keeping themseparate.

Questions with both tax and inflation are best tackledusing the money method.

Inflate costs and revenues, where necessary, beforedetermining their tax implications.

Ensure that the cost and disposal values have beeninflated (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 thetiming and the amount of tax paid on the project’s cash

flows and the tax saved on capital allowances

Working capital

Work out the changes in working capital, these become thecash flows for the NPV – don’t forget to run working capital

down to zero in the final year.

Inflation

If there is 1 rate of inflation – ignore inflation (use real cashflows 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).

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ACCA F9 Lecture 3