ACCA Paper F9 Financial Management Study Materials F9FM Session05 d08

OVERVIEW

Objective

¾

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

¾

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

¾

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

¾

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

RELEVANT COSTS

WORKING CAPITAL TAXATION

¾ General rule

¾ Layout of cash flows

¾ Basic effect of the UK tax

system

¾ Timing

¾ Other assumptions

¾ Dealing with taxation

INFLATION

¾ Why inflation is a problem

¾ Real and money interest rates

¾ General and specific inflation

rates

¾ Cash flow forecasts

1

RELEVANT COSTS FOR DISCOUNTING

1.1

General rule

Include only those costs and revenues which are affected by the decision. This means using only:

¾

future;

¾

Incremental;

¾

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:

¾

sunk costs – money already spent;

¾

non-cash costs – e.g. depreciation;

¾

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

¾

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

¾

finance costs – e.g. interest (discounting the operating cash flows already deals with this). However, include:

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.

Solution

Costs and revenues of proceeding with the project.

$ (1) Costs to date –

(2) Materials –

(3) Labour cost –

Absorption of overheads – (4) Research staff costs

Wages

Redundancy pay (5) Equipment

(6) General building services Apportioned costs Opportunity costs

_______

Sales value of project

Increased contribution from project _______

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 Discount factor/

annuity factor

0 Machine (10,000) 1 (10,000)

1−2 Project

income 7,000 1.626 11,382

______ NPV $1,382 ______ or

(ii) 0 1 2

Machine (10,000)

Income 7,000 7,000

______ ______ ______

(10,000) 7,000 7,000

15% factor 1 0.870 0.756

______ ______ ______

Present

value (10,000) 6,090 5,292

NPV = $1,382 ______

Commentary

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

¾

Operating results = revenues – operating costs

¾

Any tax relief on finance costs is taken into account in the

discount rate/cost of capital.

¾

Depreciation expense from the financial statements is not a tax allowable

deduction in the UK

¾

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

¾

Details:

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

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,

T0 Year 1 T1 T2

¾

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)

¾

If asset bought at start of year 1

First WDA received at T1 (date of next tax assessment) Reduces tax payment at T2

¾

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?

Solution

Tax saving

@ 30% Timing

$ $ $

Cost

Year 1 WDA 25% (1,250) 5,000 375 T2

______ WDV c/f

Year 2 WDA 25% 3,750 (938) 281 T3

______ WDV c/f

Year 3 Disposal (1,000) 2,812 Balancing allowance ______ 1,812

2.3

Other assumptions

¾

Tax rate is constant.

¾

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

¾

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

T0 T₁ T₂ T₃

REVENUE

Step 2 (a) Put in revenues Revenue x x

and operating costs

Operating costs (x) (x)

— — — —

(b) Total columns for net Net revenue x x revenues

(c) Calculate tax payable on net Tax @ 30% (x) (x) revenues

CAPITAL

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

disposal value Scrap proceeds 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 5 Cost of capital = 10%

Required:

Calculate the project’s NPV.

Solution

T0 T1 T2 T3

Net cash inflows Tax @ 33% Asset

Scrap proceeds

Tax savings on WDAs (W) Net cash flow

Discount factor Present value

_______ _______ _______ _______

WORKING

T0 PROFITS T1 T2

IN YEAR 1

¾ Asset purchased 1 Jan 19.01

¾ First WDA will be set off against profits earned in year 1 (T1)

¾ First tax saving at T2

¾ Asset sold 31 Dec 19.02

¾ No WDA in year of sale

¾ Balancing

$ Tax relief at

33% Timing T0 Investment in asset

Year 1 WDA @ 25%

_______ Year 2 Proceeds

_______ Balancing allowance

Example 3

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 5 Cost of capital = 10%

Required:

Calculate the project’s NPV.

Solution

T0 T1 T2 T3 Net cash inflows

Tax @ 33% Asset

Tax saving on WDA (W) (10,000)

5,000 5,000

(1,650) (1,650)

Net cash flow Discount factor Present value

_______ _______ _______ _______

WORKING Tax computation

T0 T1 T2

PROFITS IN YEAR 0

¾

Asset purchased 31 Dec 19.00

¾

First WDA will be set off

against profits earned in prior year

¾

First tax relief at T1

¾

Asset scrapped 31 Dec 19.02

¾

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%

_______

Year 2 Proceeds –

_______ Balancing allowance

3

INFLATION

3.1

Why inflation is a problem for project appraisal

¾

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

¾

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

¾

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

¾

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

3.2

Real and money (or nominal) interest rates

¾

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

¾

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 year.

In one year, in the absence of inflation, you require $100 × 1.05 = $105

To maintain the purchasing power of your investment, i.e. to cover inflation you require

$105 × 1.1 = $115.50

You therefore require a money return of 100

50 .

15 _{= 15.5% over the year.}

¾

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

3.3

General and specific inflation rates

¾

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

¾

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:

3.4.1

Current cash flows

¾

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

3.4.2

Money (or nominal) cash flows

¾

Cash flows are inflated to future price levels using the specific inflation rate for each type of revenue/cost.

¾

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

3.4.3

Real cash flows

¾

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.

3.5.1

Money method

¾

Adjust each cash flow for specificinflation to convert to nominal/money cash flows.

¾

Discount using the nominal/money cost of capital.

3.5.2

Real method

¾

Remove the effects of general inflation from money cash flows to generate real cash flows.

¾

Discount using the real cost of capital.

3.5.3

Effective method

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%

Solutions

Money method

T0 T1 Outlay (5)

Sales 10 × 1.05 = 10.5

Costs _{___} (3) × 1.03 = (3.09) _{_____}

Money flows (5) 7.41

NPV = (5) + 7.41_{1.06 = $1.99m}

Real method

T0 T1 Money cash flow (5) 7.41

RPI 4% 7.41_1.04

Real cash flow (5) 7.125 (1 + i) = (1 + r) (1 + h)

(1.06) = (1 + r) (1.04) r = 1.92307%

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.

Effective method

¾

Effective discount rates: for sales:

(1.06) = (1 + e) (1.05) e = 0.95238% for costs (1.06) = (1 + e) (1.03)

e = 2.91262%

¾

Technique

Discount cash flows expressed in current terms at effective rates

NPV = (5) +

1.0291262 (3)

1.009523810 + = $1.99m

as before

¾

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:

Solution

(i)

Money method

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

i =

t $ DF PV

$ 1

2

3 _{______}

______

(ii)

Real method

t $ DF PV

$ 1

2 3

(W)

______ ______

WORKING

(iii)

Effective method

e =

t $ DF PV

$

1–3 (W)

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. Ignore taxation.

Solution

(i)

Money method

T0 T1 T2 T3

$ $ $ $

Investment Materials Labour savings Overhead savings

(10,000)

______ _____ _____ _____

Net cash flow Discount factor

Present value ______ _{______} _____ _{_____}

_____ _____

_____ _____

(ii)

Effective method

(a) Calculation of effective rates

Materials

e = =

Labour

e = =

Overheads

e = =

(b) Discount flows at effective rates

Time Cash flow Discount/ annuity factor

Present value

0 1−3 1−3 1−3

Investment Material cost Labour saving Overhead saving

(10,000) 1

(W) † †

(10,000)

Net present value _____ _{_____}

† from tables

(iii)

Real method

T0 T1 T2 T3

Money cash flows (10,000) 4,780 5,080 5,403

÷

Real cash flows Discount factor Present value NPV =

Real rate: (1+i) = (1+r)(1+h) =

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.

Required:

Determine whether the company should proceed with the project.

Solution

WDA’s

$ Tax @ 33% Time y/e 31 December 19.04

Purchase

WDA @ 25% 250,000 _{______}

y/e 31 December 19.05

WDA @ 25% _{______}

y/e 31 December 19.06

WDA @ 25% _{______}

y/e 31 December 19.07 Sales proceeds Balancing allowance

Project appraisal

T0 T1 T2 T3 T4 T5

Inflows Tax @ 33%

Initial investment Scrap

Tax saving on WDA’s

_______ _______ _______ _______ _______ _______

DF

_______ _______ _______ _______ _______ _______ PV

_______ _______ _______ _______ _______ _______ NPV =

Therefore,

4

WORKING CAPITAL

At the start of a project we usually see a cash outflow for the investment in non-current assets e.g. plant and equipment. However many projects will also require an investment in net current assets i.e. working capital. For project appraisal working capital is defined as inventory + accounts receivable – accounts payable. Note that this definition excludes cash – the cash flow is found as the change in the level of inventory + accounts receivable –

accounts payable.

Movements in working capital need to be incorporated into investment appraisals. Cash flows are derived as follows:

¾

Increase in net working capital = cash outflow;

¾

Decrease in net working capital = cash inflow.

¾

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.

¾

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 expected.

Required:

Determine the total cash flow for each year.

Solution

T0 T1 T2 T3 T4

$ $ $ $ $

Contribution

Cash re working capital (W) Total cash flow

(W) Sales

Key points

³

The golden rule – only discount future, incremental, operating cash flows.

³

Never discount depreciation – it is not a cash flow.

³

Do not discount finance costs – the cost of finance is measured in the discount rate and is therefore already taken into account.

³

Exam 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.

³

Discounting 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.

³

Adjusting 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:

¾

distinguish relevant from non-relevant costs for investment appraisal;

¾

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

¾

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

¾

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

¾

evaluate capital investment projects on a real terms basis;

¾

evaluate capital investment projects on a nominal terms basis;

EXAMPLE SOLUTIONS

Solution 1 — Relevant costs

Costs and revenues of proceeding with the project.

$ (1) Costs to date of $150,000 sunk – ∴ ignore. – (2) Materials – purchase price of $60,000 is also sunk.

Opportunity benefit is disposal costs saved. 5,000 (3) Labour cost – direct cost of $40,000 will be incurred

regardless of whether or not the project is undertaken– and so is not relevant. Opportunity cost of lost

contribution = 150,000 – (100,000 – 40,000) (90,000) Absorption of overheads – irrelevant as it is merely an

apportionment of existing costs –

(4) Research staff costs Wages for the year

Redundancy pay increase (35,000 – 15,000) (60,000) (20,000) (5) Equipment

Deprival value if used in the project = disposal value Disposal proceeds in one year

(8,000) 6,000 (6) General building services

Apportioned costs irrelevant

Opportunity costs rental forgone (7,000) – ________ (174,000)

Sales value of project 300,000

Solution 2 — Tax cash flows

T0 T1 T2 T3 Net cash inflows

Tax @ 33%

10% discount factor Present Value

¾ Asset purchased 1 Jan 19.01

¾ First WDA will be set off against profits earned in year 1 (T1)

T0 Investment in asset 10,000

Year 1 WDA @ 25% (2,500) 825 T2

_______ 7,500

Year 2 Proceeds (6,000)

_______

Solution 3 — Tax cash flows

T0 T1 T2 T3 Net cash inflows

Tax @ 33%

10% discount factor Present value

¾

Asset purchased 31 Dec 19.00

¾

First WDA will be set off

against profits earned in prior year

¾

First tax relief at T1

¾

Asset scrapped 31 Dec 19.02

¾

No WDA in year of sale

Solution 4 — Money, real and effective methods

(iii)

Effective method

Solution 5 — Money, real and effective methods

Labour savings (5%) Overhead savings (10%)

(10,000)

______ _____ _____ _____

Net cash flow (10,000) 4,780 5,080 5,403

Present value (10,000) ______ _{______} _____ _{_____}4,139

_____

(ii)

Effective method

(a) Calculation of effective rates

Materials (1.155)

e = = (1 + e)(1.08) 6.94%

Labour (1.155)

e = = (1 + e)(1.05) 10% Overheads (1.155)

e = = (1 + e)(1.05) 5%

(b) Discount flows at effective rates

Time Cash flow Discount/

Net present value _____ _{_____}1,453

(iii)

Real method

T0 T1 T2 T3

Money cash flows (10,000) 4,780 5,080 5,403

÷ 1 1.07 1.072 _1.073

Real cash flows (10,000) 4,467 4,437 4,410

Discount factor @ 7.944% 1 0.926 0.858 0.795

Present value (10,000) 4,136 3,807 3,506

NPV = $1,449

Real rate : (1+i) = (1+r)(1+h) 1.155 = (1+r)(1.07)

r = 7.944%

Solution 6 — Tax and inflation

WDA’s

Tax @ 33% Time y/e 31 December 19.04

Purchase

WDA @ 25% (62,500) 250,000 _{______} 20,625 T2 187,500

y/e 31 December 19.05

WDA @ 25% (46,875) _{______} 15,469 T3

140,625 y/e 31 December 19.06

WDA @ 25% (35,156) _{______} 11,602 T4

105,469 y/e 31 December 19.07

Sales proceeds (50,000)

Balancing allowance

______ 55,469

Project appraisal

T0 T1 T2 T3 T4 T5

Inflows 84,000 88,200 92,610 97,241

Tax @ 33% (27,720) (29,106) (30,561) (32,090)

Initial investment (250,000)

Scrap 50,000

WDA’s 20,625 15,469 11,602 18,305

_______ _______ _______ _______ _______ _______ (250,000) 84,000 81,105 78,973 128,282 (13,785)

DF @ 15% 1 0.870 0.756 0.658 0.572 0.497

_______ _______ _______ _______ _______ _______

PV (250,000) 73,080 61,315 51,964 73,377 (6,851)

_______ _______ _______ _______ _______ _______ NPV = $2,885

Therefore, accept the project

Solution 7 — Working capital

T0 T1 T2 T3 T4

$ $ $ $ $

Contribution

Cash re working capital (W) Total cash flow

(W) Sales

Level of working capital Cash re working capital