ACCA paper f9 financial management study materials F9FM session05 d08

Do not include financing cash flows because the cost of finance is measured in the cost of capital/discount rate - finance costs are taken into account by the discounting process itself

OVERVIEW

Objective

Ü To recognise the costs that are relevant to a discounted cash flow analysis

Ü To be able to determine the taxation effects of a new investment

Ü To be able to deal with inflation using either the money method, real method or

effective method

Ü To do able to deal with cash flows relating to working capital

RELEVANT COSTS

WORKING CAPITAL TAXATION

Ü General rule

Ü Layout of cash flows

Ü Basic effect of the UK tax

Ü Why inflation is a problem

Ü Real and money interest rates

Ü General and specific inflation

rates

Ü Cash flow forecasts

Ü Discounting

1 RELEVANT COSTS FOR DISCOUNTING

Ü operating cash flows

Operating cash flows means the cash flows generated from operating the project e.g cash

from sales, less operating costs such as materials and labour

Do not include financing cash flows because the cost of finance is measured in the cost of

capital/discount rate - finance costs are taken into account by the discounting process itself

Specifically, exclude:

Ü sunk costs – money already spent;

Ü non-cash costs – e.g depreciation;

Ü book values – e.g FIFO/LIFO inventory values;

Ü unavoidable costs – money already committed e.g apportioned fixed costs;

Ü finance costs – e.g interest (discounting the operating cash flows already deals with this)

However, include:

Ü all opportunity costs and revenues e.g ‘cannibalisation’; where the launch of a new

product will reduce the sales if an exiting product The lost contribution is an

opportunity cost and should be shown as a cash outflow

Example 1

A research project, which to date has cost the company $150,000, is under

review

If the project is allowed to proceed, it will be completed in approximately one

year, when the results would be sold to a government agency for $300,000

Shown below are the additional expenses which the managing director

estimates will be necessary to complete the work

Materials

This material has just been purchased at a cost of $60,000 It is toxic and, if not

used in this project, must be disposed of at a cost of $5,000

Labour

Skilled labour is hard to recruit The workers concerned were transferred to

the project from a production department, and at a recent meeting the

production manager claimed that if the men were returned to him they could

generate sales of $150,000 in the next year The prime cost of these sales would

be $100,000, including $40,000 for the labour cost itself The overhead

absorbed into this production would amount to $20,000

Research staff

It has already been decided that, when work on this project ceases, the research

department will be closed Research wages for the year are $60,000, and

redundancy and severance pay has been estimated at $15,000 now or $35,000 in

one year’s time

Equipment

The project utilises a special microscope which cost $18,000 three years ago It

has a residual value of $3,000 in another two years, and a current disposal

value of $8,000 If used in the project it is estimated that the disposal value in a

year’s time will be $6,000

Share of general building services

The project is charged with $35,000 per annum to cover general building

expenses Immediately the project is discontinued, the space occupied could

be sub-let for an annual rental of $7,000

Required:

Advise the managing director as to whether the project should be allowed to

proceed, explaining the reasons for the treatment of each item

(Ignore the time value of money.)

Solution

Costs and revenues of proceeding with the project

$ (1) Costs to date –

Sales value of project

_

Advice:

1.2 Layout of cash flows

A company invests $10,000 today in a machine It expects to earn $7,000 per year for two years as a result Discount rate = 15%

Calculate the net present value of the investment

(i) Time Narrative Cash flow 15% Present

Commentary

In complex exam questions it is usually better to present your answer using the

second format i.e with columns for years

2 TAXATION

2.1 Basic effect of the UK tax system

Taxation has two effects in investment appraisal

Tax charged

on operating results

Tax relief given

on non-current assets

via

WRITING DOWN ALLOWANCES

NEGATIVE EFFECT POSITIVE EFFECT

Ü Operating results = revenues –

operating costs

Ü Any tax relief on finance costs is

taken into account in the

discount rate/cost of capital

Ü Depreciation expense from the financial

statements is not a tax allowable

deduction in the UK

Ü Instead companies can claim Writing Down Allowances (WDA’s), also called Capital Allowances (CA’s)

Ü Details:

̌ Often given at 25% reducing balance – but exam question will tell you the policy

̌ no WDA in year of sale; balancing allowance/charge given instead, representing a tax loss/gain on disposal

2.2 Timing

The timing of tax cash flows is complex Some exam questions will tell you that tax is paid

in the year of taxable profits, other questions will tell you tax is paid "one year in arrears” i.e

in the following year,

Ü Assume net revenues (revenues minus operating costs) are received at the end of year 1 (T1)

Tax assessed at T1

Tax paid T2 (assuming tax is paid one year in arrears)

Ü If asset bought at start of year 1

First WDA received at T1 (date of next tax assessment)

Reduces tax payment at T2

Ü However if the asset is bought on the last day of the previous year i.e on the date of a tax

assessment, the first WDA would be received immediately i.e at T0 , which reduces the tax payment at T1

Illustration 1

An asset is bought for $5,000 at the start of an accounting period It is sold at

the end of the third accounting period for $1,000

Corporation tax is 30% and paid one year in arrears Writing down allowances

are available at 25% reducing balance

What are the tax savings available and when do they arise?

2.3 Other assumptions

Ü Tax rate is constant

Ü Sufficient taxable profits are available to use all tax deductions in full

Ü Working capital flows have no tax effects e.g if the level of accounts receivable rises this does not change the tax situation as tax is charged when revenues are recorded rather than when the cash is received (see additional notes on working capital in the last section of this chapter)

2.4 Dealing with taxation

Step 1 Set up table

REVENUE

and operating costs

Step 3 Put in capital outlay and any Investment (x)

Step 4 Calculate tax saving on WDAs WDA tax savings x x

(x) x x (x)

Step 5 Total columns for net cash flows

and discount Discount factor r% x x x x

Present value (x) x x x

Example 2

1 A company buys an asset for $10,000 at the beginning of an accounting

period (1 January 19.01) to undertake a two year project

2 Net cash inflows received at the end of year 1 and year 2 are $5,000

3 The company sells the asset on the last day of the second year for $6,000

4 Corporation tax = 33% (paid one year in arrears)

Writing down allowance = 25% reducing balance

Tax savings on WDAs (W)

Net cash flow

Ü Asset purchased 1 Jan 19.01

Ü First WDA will be set off

against profits earned in year

1 (T1)

Ü First tax saving at T2

Ü Asset sold 31 Dec 19.02

Ü No WDA in year of sale

Ü Balancing allowance/charge

1 A company buys an asset for $10,000 at the end of the previous accounting

period (31 December 19.00) to undertake a two year project

2 Net cash inflows received at the end of year 1 and year 2 are $5,000

3 The asset has zero scrap value when it is disposed of at the end of year 2

4 CT = 33% (paid one year in arrears)

WDA = 25% reducing balance

Ü Asset purchased 31 Dec 19.00

Ü First WDA will be set off

against profits earned in prior

year

Ü First tax relief at T1

Ü Asset scrapped 31 Dec 19.02

Ü No WDA in year of sale

$ Tax relief at 33% Timing

T0

Year 0 Investment in asset WDA @ 25% (2,500) 10,000 825

_

7,500 Year 1 WDA @ 25%

3.1 Why inflation is a problem for project appraisal

Ü It is hard to estimate, especially when rates are high

Ü It causes governments to take actions which may impact on business e.g raising interest rates, cutting state spending

Ü Differential inflation rates will occur; different costs and revenues will inflate at

different rates

Ü It alters the cost of capital (in nominal terms)

Ü It makes historic costs irrelevant and therefore causes ROCE to be overstated

Ü It creates uncertainty for customers, which may lead to lower demand

Ü It encourages managers to become short-term in outlook

3.2 Real and money (or nominal) interest rates

Ü Real rate of interest reflects the rate of interest that would be required in the absence of inflation

Ü Money (or nominal) rate of interest reflects the real rate of interest adjusted for the effect

of general inflation (measured by the CPI – the Consumer Price Index)

Illustration 2

Suppose you invest $100 today for one year and, in the absence of inflation,

you require a return of 5% The CPI is expected to rise by 10% over the coming

15 = 15.5% over the year

Ü Money rates, real rates and general inflation (CPI) are linked by the Fisher formula: (1+money rate) = (1+real rate) (1+general inflation rate)

(1+i) = (1+r) (1+h)

i = nominal/money interest rate

r = real interest rate

h = general inflation rate

In the example above

(1 + i) = (1.05) (1.1) = 1.155

i = 15.5%

3.3 General and specific inflation rates

Ü A specific inflation rate is the rate of inflation on an individual item e.g wage inflation, materials price inflation

Ü The general inflation rate is a weighted average of many specific inflation rates, e.g CPI

3.4 Cash flow forecasts

If there is inflation in the economy there are three ways in which the cash flow forecast for project appraisal can be performed:

Ü Cash flows expressed at today’s prices i.e before the effects of inflation

Ü Cash flows are inflated to future price levels using the specific inflation rate for each type

of revenue/cost

Ü This produces a forecast of the physical amount of money that will move in/out of the company

Ü Money cash flows with the effect of general inflation removed

3.5 Discounting

There are three methods of discounting if there is inflation Each method results in the same NPV

Ü Adjust each cash flow for specific inflation to convert to nominal/money cash flows

Ü Discount using the nominal/money cost of capital

Ü Express each type of cash flow in current terms i.e at t0 prices

Ü Discount at the effective rate for that cash flow

Illustration 3

One year project

Outlay at T0 = $5m

Sales for the year are expected to be $10m in current terms, with an expected

specific inflation rate of 5%

Costs for the year are expected to be $3m in current terms, with an expected

specific inflation rate of 3%

CPI expected to rise by 4%

Nominal cost of capital = 6%

Commentary

⇒ As money flows are needed to do this, the money method might just as well be

used – it gives the same result

⇒ Net cash flow expressed in current terms ($7m) is not the same as real cash flow

($7.125m), because sales and costs are not changing at CPI

as before

Ü Effective method can be useful where an annuity is given in today’s prices

Example 4

A project produces a cash inflow at the end of years 1–3 of $10,000 (at t0 prices)

Real cost of capital = 10%

CPI = 5%

Inflation of project cash flows = 8%

Required:

Calculate NPV using:

(i) money method

(ii) real method

(iii) effective method

Example 5

1 A company buys a machine today for $10,000

2 Material costs at current prices will be $1,500 pa for three years

Material costs inflate at 8% pa

3 Labour savings at current prices will be $4,000 pa for three years

Labour costs inflate at 5% pa

4 Overhead savings at current prices will be $2,000 pa for three years

Overhead costs inflate at 10% pa

5 Money cost of capital = 15.5%

6 General inflation = 7%

Required:

Calculate the NPV of the project, using:

(i) the money method;

(ii) the effective method;

(iii) the real method

(ii) Effective method

(a) Calculation of effective rates

(b) Discount flows at effective rates

annuity factor

Present value

0 1−3 1−3 1−3

Investment Material cost Labour saving Overhead saving

(W)

†

† (10,000)

Example 6

A company is considering a project which requires the purchase of a machine

costing $250,000 on 1 January 19.04 Net inflows from the project are expected

to be $80,000 per annum in current terms for the next four years At the end of

the project it is estimated that the machine will be sold for cash proceeds of

$50,000

The company has a December year end and pays tax at 33%, 12 months after

the end of the accounting period The project flows are expected to inflate at

5%, and the company’s money cost of capital is 15% Writing Down

Allowances are given at 25% reducing balance

creating a cash inflow

Movements in working capital need to be incorporated into investment appraisals Cash

flows are derived as follows:

Ü Increase in net working capital = cash outflow;

Ü Decrease in net working capital = cash inflow

Ü Unless the question tells you otherwise assume that working capital is “released” at the end of a project i.e the investment in working capital falls to zero, creating a cash

inflow

Ü Assume that changes in the level of working capital have no tax effects This is a

realistic assumption because tax will be charged when net revenues accrue rather than when the cash is received

Example 7

Sales of a new product are forecast at $100,000 in the first year, increasing by

10% compound per annum The product has a four year life cycle Working

capital equal to 15% of annual sales is required at the start of each year The

company’s contribution margin is 40% and no incremental fixed costs are

Cash re working capital (W)

Total cash flow

(W)

Sales

Level of working capital

Cash re working capital

Key points

ÐThe golden rule – only discount future, incremental, operating cash flows

ÐNever discount depreciation – it is not a cash flow

ÐDo not discount finance costs – the cost of finance is measured in the

discount rate and is therefore already taken into account

ÐExam questions will be in the environment o the UK tax system

Depreciation expense is not a tax allowable deduction in the UK – instead

companies can claim Writing Down Allowances/Capital Allowances

ÐDiscounting with inflation is a difficult area The key here is consistency

i.e if inflation is included in the cash flow forecast then make sure you

include it in the discount rate

ÐAdjusting for changes in working capital is relevant if you are given

accruals-based accounting information which needs to be converted to a

cash flow basis

FOCUS

You should now be able to:

Ü distinguish relevant from non-relevant costs for investment appraisal;

Ü calculate the effect of Writing Down allowances and corporation tax on project cash flows;

Ü explain the relationship between inflation and interest rates, distinguishing between real and nominal rates;

Ü distinguish general inflation from specific price increases and assess their impact on cash flows;

Ü evaluate capital investment projects on a real terms basis;

Ü evaluate capital investment projects on a nominal terms basis;

Ü evaluate capital investment projects on a current/effective terms basis;