ACCA paper f9 financial management study materials F9FM session05 d08

SESSION 05 – RELEVANT CASH FLOWS FOR DCF OVERVIEW Objective To recognise the costs that are relevant to a discounted cash flow analysis To be able to determine the taxation effects of a new investment To be able to deal with inflation using either the money method, real method or effective method To able to deal with cash flows relating to working capital RELEVANT COSTS General rule Layout of cash flows TAXATION INFLATION WORKING CAPITAL Basic effect of the UK tax system Timing Other assumptions Dealing with taxation Why inflation is a problem Real and money interest rates General and specific inflation rates Cash flow forecasts Discounting 0501 SESSION 05 – RELEVANT CASH FLOWS FOR DCF RELEVANT COSTS FOR DISCOUNTING 1.1 General rule Include only those costs and revenues which are affected by the decision This means using only: future; Incremental; 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: sunk costs – money already spent; non-cash costs – e.g depreciation; book values – e.g FIFO/LIFO inventory values; unavoidable costs – money already committed e.g apportioned fixed costs; finance costs – e.g interest (discounting the operating cash flows already deals with this) However, include: 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 0502 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Example 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.) 0503 SESSION 05 – RELEVANT CASH FLOWS FOR DCF 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 Advice: 0504 _ _ _ SESSION 05 – RELEVANT CASH FLOWS FOR DCF 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 1−2 Machine Project income (10,000) 7,000 15% Present Discount factor/ annuity factor (10,000) 1.626 11,382 NPV $1,382 or (ii) Machine (10,000) Income 7,000 7,000 (10,000) 15% factor 7,000 0.870 7,000 0.756 6,090 5,292 Present value (10,000) NPV = $1,382 Commentary In complex exam questions it is usually better to present your answer using the second format i.e with columns for years 0505 SESSION 05 – RELEVANT CASH FLOWS FOR DCF TAXATION 2.1 Basic effect of the UK tax system Taxation has two effects in investment appraisal NEGATIVE EFFECT Tax charged on operating results POSITIVE EFFECT Tax relief given on non-current assets via WRITING DOWN ALLOWANCES Operating results = revenues – operating costs Any tax relief on finance costs is taken into account in the discount rate/cost of capital Depreciation expense from the financial statements is not a tax allowable deduction in the UK Instead companies can claim Writing Down Allowances (WDA’s), also called Capital Allowances (CA’s) 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 0506 SESSION 05 – RELEVANT CASH FLOWS FOR DCF 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 T1 T2 Assume net revenues (revenues minus operating costs) are received at the end of year (T1) Tax assessed at T1 Tax paid T2 (assuming tax is paid one year in arrears) If asset bought at start of year First WDA received at T1 (date of next tax assessment) Reduces tax payment at T2 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 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 they arise? Solution Cost Year WDA 25% $ 5,000 (1,250) WDV c/f Year WDA 25% 3,750 (938) WDV c/f Year Disposal 2,812 (1,000) Balancing allowance 1,812 Tax saving @ 30% $ Timing 375 T2 281 T3 544 T4 $ 0507 SESSION 05 – RELEVANT CASH FLOWS FOR DCF 2.3 Other assumptions Tax rate is constant Sufficient taxable profits are available to use all tax deductions in full 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 Set up table REVENUE Step (a) Put in revenues and operating costs T0 Revenue Operating costs (b) Total columns for net revenues Net revenue (c) Calculate tax payable on net revenues Tax @ 30% CAPITAL Step Put in capital outlay and any disposal value Investment Scrap proceeds Step Calculate tax saving on WDAs WDA tax savings Step Total columns for net cash flows and discount 0508 — T1 T2 x x (x) — (x) — x x (x) (x) T3 — (x) x — (x) — x x — x x — (x) Discount factor r% x — Present value (x) — x — x — x — x — x — x — SESSION 05 – RELEVANT CASH FLOWS FOR DCF Example 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 Net cash inflows received at the end of year and year are $5,000 The company sells the asset on the last day of the second year for $6,000 Corporation tax = 33% (paid one year in arrears) Writing down allowance = 25% reducing balance 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 IN YEAR T1 Asset purchased Jan 19.01 First WDA will be set off against profits earned in year (T1) First tax saving at T2 T2 Asset sold 31 Dec 19.02 No WDA in year of sale Balancing allowance/charge 0509 SESSION 05 – RELEVANT CASH FLOWS FOR DCF $ T0 Year Investment in asset WDA @ 25% Year Proceeds Tax relief at 33% Timing _ _ Balancing allowance Example 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 Net cash inflows received at the end of year and year are $5,000 The asset has zero scrap value when it is disposed of at the end of year CT = 33% (paid one year in arrears) WDA = 25% reducing balance Cost of capital = 10% Required: Calculate the project’s NPV Solution Net cash inflows Tax @ 33% Asset Tax saving on WDA (W) Net cash flow Discount factor Present value NPV = 0510 T0 T1 5,000 T2 5,000 (1,650) (1,650) _ _ _ (10,000) _ T3 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Solution (i) Money method (1 + i) = (1 + r) (1 +h) = i= t $ DF PV $ (ii) Real method t $ (W) DF PV $ WORKING (iii) Effective method e= t 1–3 WORKING 0516 $ DF (W) PV $ SESSION 05 – RELEVANT CASH FLOWS FOR DCF Example A company buys a machine today for $10,000 Material costs at current prices will be $1,500 pa for three years Material costs inflate at 8% pa Labour savings at current prices will be $4,000 pa for three years Labour costs inflate at 5% pa Overhead savings at current prices will be $2,000 pa for three years Overhead costs inflate at 10% pa Money cost of capital = 15.5% 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 Investment Materials Labour savings Overhead savings Net cash flow Discount factor Present value T0 $ (10,000) T1 $ T2 $ T3 $ _ _ _ _ _ _ _ _ _ NPV = 0517 SESSION 05 – RELEVANT CASH FLOWS FOR DCF (ii) Effective method (a) Calculation of effective rates Materials Labour Overheads (b) e = = e = = e = = Discount flows at effective rates Time 1−3 1−3 1−3 Cash flow Investment Material cost Labour saving Overhead saving (10,000) Discount/ annuity factor (W) † † Net present value Present value (10,000) _ _ † from tables (iii) Real method T0 (10,000) Money cash flows ÷ Real cash flows Discount factor Present value NPV = Real rate: (1+i) = = r 0518 = (1+r)(1+h) T1 4,780 T2 5,080 T3 5,403 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Example A company is considering a project which requires the purchase of a machine costing $250,000 on 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 y/e y/e y/e y/e 31 December 19.04 Purchase WDA @ 25% 31 December 19.05 WDA @ 25% 31 December 19.06 WDA @ 25% 31 December 19.07 Sales proceeds Balancing allowance $ Tax @ 33% Time 250,000 0519 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Project appraisal T0 T1 T2 T3 T4 T5 _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ Inflows Tax @ 33% Initial investment Scrap Tax saving on WDA’s DF PV NPV = Therefore, 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 For example at the start of the project inventory must be purchased, causing a cash outflow Over the life of the project the level of accounts receivable may rise, with the result that cash inflows are less than the sales revenues On the other hand the level of accounts payable may also rise, reducing the required investment in working capital and improving the cash flows because payments to suppliers are below the level of purchases At the end of the project the inventory levels may be reduced to zero, all receivables may be collected, creating a cash inflow 0520 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Movements in working capital need to be incorporated into investment appraisals Cash flows are derived as follows: Increase in net working capital = cash outflow; Decrease in net working capital = cash inflow 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 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 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 Level of working capital Cash re working capital 0521 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Key points The golden rule – only discount future, incremental, operating cash flows Never discount depreciation – it is not a cash flow Do not discount finance costs – the cost of finance is measured in the discount rate and is therefore already taken into account 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 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 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: distinguish relevant from non-relevant costs for investment appraisal; calculate the effect of Writing Down allowances and corporation tax on project cash flows; explain the relationship between inflation and interest rates, distinguishing between real and nominal rates; distinguish general inflation from specific price increases and assess their impact on cash flows; evaluate capital investment projects on a real terms basis; evaluate capital investment projects on a nominal terms basis; evaluate capital investment projects on a current/effective terms basis; incorporate cash flows relating to changes in the level of working capital 0522 SESSION 05 – RELEVANT CASH FLOWS FOR DCF EXAMPLE SOLUTIONS Solution — 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 (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) Absorption of overheads – irrelevant as it is merely an apportionment of existing costs (4) (90,000) – (60,000) (20,000) Equipment Deprival value if used in the project = disposal value Disposal proceeds in one year (6) 5,000 Research staff costs Wages for the year Redundancy pay increase (35,000 – 15,000) (5) $ – (8,000) 6,000 General building services Apportioned costs irrelevant Opportunity costs rental forgone – (7,000) Sales value of project (174,000) 300,000 Increased contribution from project 126,000 Advice Proceed with the project 0523 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Solution — Tax cash flows T0 Net cash inflows Tax @ 33% Asset Scrap proceeds Tax savings on WDAs (W) T1 5,000 (10,000) Net cash flow 10% discount factor Present Value T2 5,000 (1,650) (1,650) 495 _ (1,155) 0.751 (867) _ _ 6,000 825 _ (10,000) (10,000) 5,000 0.909 4,545 10,175 0.826 8, 405 T3 NPV = $2, 083 Accept project WORKING Tax computation T0 PROFITS IN YEAR T1 Asset purchased Jan 19.01 First WDA will be set off against profits earned in year (T1) First tax relief at T2 T2 Asset sold 31 Dec 19.02 No WDA in year of sale $ T0 Year Year Investment in asset WDA @ 25% 10,000 (2,500) _ Proceeds 7,500 (6,000) _ Balancing allowance 0524 (1,500) Tax relief at 33% Timing 825 T2 495 T3 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Solution — Tax cash flows T0 Net cash inflows Tax @ 33% Asset Tax saving on WDA (W) T1 5,000 T2 5,000 (1,650) (1,650) _ 825 _ 619 _ 1,856 _ (10,000) (10,000) 5,825 0.909 5,295 3,969 0.826 3, 278 206 0.751 155 (10,000) Net cash flow 10% discount factor Present value T3 NPV = $(1, 272) Reject project WORKING Tax computation PROFITS IN YEAR T0 T1 Asset purchased 31 Dec 19.00 First WDA will be set off against profits earned in prior year First tax relief at T1 T2 Asset scrapped 31 Dec 19.02 No WDA in year of sale T0 Year Investment in asset WDA @ 25% $ 10,000 (2,500) _ Year WDA @ 25% 7,500 (1,875) _ Year Proceeds 5,625 – _ Balancing allowance 5,625 Tax relief at 33% Timing 825 T1 619 T2 1,856 T3 0525 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Solution — Money, real and effective methods (i) Money method (1 + i) = (1 + r) (1 + h) = 1.1 × 1.05 = 1.155 m = 15.5% T $ 10,800 11,664 12,597 DF (15.5%) 0.866 0.75 0.649 PV $ 9,353 8,748 8,175 26,276 (ii) Real method T $ 10,286 (W) 10,580 10,882 DF (10%) 0.909 0.826 0.751 PV $ 9,350 8,739 8,172 26,261 WORKING 10 ,800 1.05 (iii) Effective method 1.155 = (1 + e) 1.08 e = 6.94 T 1–3 $ 10,000 WORKING    = 2.627 1 − 0.0694  1.0694  0526 DF 2.627 (W) PV $ 26,270 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Solution — Money, real and effective methods (i) Money method T0 $ (10,000) Investment Materials (8%) Labour savings (5%) Overhead savings (10%) T1 $ T2 $ T3 $ (1,620) 4,200 2,200 _ (1,750) 4,410 2,240 _ (1,890) 4,631 2,662 _ 5,080 5,403 4,780 1155 _ 1155 _ 1155 _ (10,000) 4,139 _ 3,808 _ 3,507 _ Net cash flow Discount factor @ 15.5% (10,000) Present value NPV = $1,454 (ii) Effective method (a) (b) 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% Discount flows at effective rates Time 1−3 1−3 1−3 Cash flow Investment Material cost Labour saving Overhead saving (10,000) (1,500) 4,000 2,000 Net present value Discount/ annuity factor 2.627(W) 2.487† 2.723† Present value (10,000) (3,941) 9,948 5,446 _ 1,453 _ † from tables WORKING year 6.94% annuity factor =   = 2.627 1−   0.0694  1.0694  0527 SESSION 05 – RELEVANT CASH FLOWS FOR DCF (iii) Real method Money cash flows T0 (10,000) T1 4,780 T2 5,080 T3 5,403 1.07 1.072 1.073 (10,000) 4,467 4,437 4,410 0.926 0.858 0.795 (10,000) 4,136 3,807 3,506 ÷ Real cash flows Discount factor @ 7.944% Present value NPV = $1,449 Real rate : (1+i) = (1+r)(1+h) 1.155 = (1+r)(1.07) r = 7.944% Solution — Tax and inflation WDA’s y/e y/e 31 December 19.04 Purchase WDA @ 25% 31 December 19.05 WDA @ 25% y/e 31 December 19.06 WDA @ 25% y/e 31 December 19.07 Sales proceeds Balancing allowance 0528 Tax @ 33% 250,000 (62,500) Time 20,625 T2 15,469 T3 11,602 T4 18,305 T5 187,500 (46,875) 140,625 (35,156) 105,469 (50,000) 55,469 SESSION 05 – RELEVANT CASH FLOWS FOR DCF Project appraisal T0 T1 84,000 T2 88,200 (27,720) T3 92,610 (29,106) T4 97,241 (30,561) T5 (32,090) 18,305 _ Inflows Tax @ 33% Initial investment Scrap WDA’s (250,000) _ _ 20,625 _ 15,469 _ 50,000 11,602 _ DF @ 15% (250,000) _ 84,000 0.870 _ 81,105 0.756 _ 78,973 0.658 _ 128,282 0.572 _ (13,785) 0.497 _ PV (250,000) _ 73,080 _ 61,315 _ 51,964 _ 73,377 _ (6,851) _ NPV = $2,885 Therefore, accept the project Solution — Working capital Contribution Cash re working capital (W) Total cash flow (W) Sales Level of working capital Cash re working capital T0 $ (15,000) _ T1 $ 40,000 (1,500) _ T2 $ 44,000 (1,650) _ T3 $ 48.400 (1,815) _ T4 $ 53,240 19,965 _ (15,000) _ 38,500 _ 42,350 _ 46,585 _ 73,205 _ 15,000 (15,000) _ 100,000 16,500 (1,500) _ 110,000 18,150 (1,650) _ 121,000 19,965 (1,815) _ 133,100 19,965 _ 0529 SESSION 05 – RELEVANT CASH FLOWS FOR DCF 0530 ... 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... 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... FLOWS FOR DCF 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