Chapter5 InflationTax
Chapter5 InflationTax
Chapter5 InflationTax
Dec 2015
ACCA F9
Financial Management
Premium Class
ACCA
Session 3 and 4
Patrick Lui
[email protected]
SYLLABUS
1. Inflation
(Pilot, Jun 08, Jun 09, Dec 10, Jun 11, Jun 12, Dec 12, Jun 13, Dec 13, Jun 14, Dec 14,
Jun 15)
1.1.1 It is important to adapt investment appraisal methods to cope with the phenomenon of
price movement. Future rates of inflation are unlikely to be precisely forecasted;
nevertheless, we will assume in the analysis that follows that we can anticipate
inflation with reasonable accuracy.
1.1.2 Two types of inflation can be distinguished.
(a) Specific inflation refers to the price changes of an individual good or
service.
(b) General inflation is the reduced purchasing power of money and is
measured by an overall price index which follows the price changes of a
‘basket’ of goods and services through time.
Even if there was no general inflation, specific items and sectors might experience
price rises.
The generalized relationship between real rates of interest and nominal rate of
interest is expressed as follow under Fisher’s equation:
(1 + i) = (1 + r) (1 + h)
1.2.3 EXAMPLE 1
$1,000 is invested in an account that pays 10% interest pa. Inflation is currently 7%
pa. Find the real return on the investment.
Solution:
Solution:
1.3.2 EXAMPLE 2
Storm Co is evaluating Project X, which requires an initial investment of $50,000.
Expected net cash flows are $20,000 pa for four years at today’s prices. However
these are expected to rise by 5.5% pa because of inflation. The firm’s cost of capital
is 15%. Find the NPV by:
Solution:
(a) Discounting money cash flow at the money rate: The cash flows at today’s
prices are inflated by 5.5% for every year to take account of inflation and
convert them into money flows. They are then discounted using the money
cost of capital.
Note: The question simply refers to the ‘firm’s cost of capital’. You can assume this
is the money rate – if you are given a real rate the examiner will always specify.
(b)
Calculate the real rate by removing the general inflation from the money cost of
capital:
(1 + r) = (1 + i) / (1 + h)
= (1 + 15%) / (1 + 5.5%)
= 1.09
r = 9%
The real rate can now be applied to the real flows without any further adjustments.
Time Real cash flow Discount rate PV ($)
($) @ 9%
0 (50,000) 1.000 (50,000)
1–4 20,000 3.240 64,800
NPV = 14,800
1.3.3 In situations where you are given a number of specific inflation rates, the real method
outlined above cannot be used.
1.3.4 The following gives a useful summary of how to approach examination questions.
1.3.5 If a question contains both tax and inflation, it is advisable to use the money method.
I. Inflation
1. When appraising investment projects using discounted cash flow methods, two
approaches to dealing with inflation could be used. These are:
1. to exclude inflation from the estimated future cash flows and to apply a discount
rate based on the money cost of capital.
2. to include inflation in the estimated future cash flows and to apply a discount
based on the real cost of capital.
Statement 1 Statement 2
A True True
B True False
C False True
D False False
2. To deal with the effect of inflation when appraising investment projects, two possible
approaches can be used. These are:
1. To exclude inflation from the estimated future cash flows and to apply a discount
rate expressed in real terms.
2. To adjust the estimated future cash flows by the relevant rates of inflation and to
adjust the discount rate to reflect current market rates.
Statement 1 Statement 2
A True True
B True False
C False True
D False False
3. The one year rate of inflation is expected to be 3·0%. The one year money rate of
interest is 6·3%.
A 3·30%
B 3·20%
C 9·30%
D 9·49%.
4. Dunlin plc is examining an investment opportunity that will lead to savings in staff
costs. The company uses the net present value method of investment appraisal based
on cash flows expressed in real terms. Staff costs are expected to rise at a rate of 5%
each year, whereas the general rate of inflation is expected to rise at a rate of 3% each
year. The company has a required rate of return of 10%, assuming no inflation.
What is the appropriate discount rate to use when evaluating the investment
opportunity?
A 10%
B 13%
C 13·3%
D 15·5%.
When using the net present value method of investment appraisal, the required rate of
return from investors is used as the appropriate discount factor. This rate of return
should be:
Which one of the following combinations (true/false) concerning the above statements
is correct?
Statement 1 Statement 2
A True True
B True False
C False True
D False False
6. A project consists of a series of cash outflows in the first few years followed by a
series of positive cash inflows. The total cash inflows exceed the total cash outflows.
The project was originally evaluated assuming a zero rate of inflation.
If the project were re-evaluated on the assumption that the cash flows were subject to a
positive rate of inflation, what would be the effect on the payback period and the
internal rate of return?
Payback IRR
A Increase Increase
B Decrease Decrease
C Decrease Increase
D Increase Decrease
7. Spotty Ltd plans to purchase a machine costing $18,000 to save labour costs. Labour
savings would be $10,000 in the first year and labour rates in the second year will
increase by 10%. The estimated average annual rate of inflation is 9% and the
company’s real cost of capital is estimated at 11%. The machine has a two year life
with an estimated actual salvage value of $5,000 receivable at the end of year 2. All
cash flows occur at the year end.
What is the NPV (to the nearest $10) of the proposed investment?
A $50
B $270
C $370
D $1,430
8. A project has an initial outflow at year 0 when an asset is bought, then a series of
revenue inflows at the end of each year, and then finally sales proceeds from the sale
of the asset. Its NPV is $12,000 when general inflation is zero % per year.
If general inflation were to be rise to 7% per year, and all revenue inflows were subject
to this rate of inflation but the initial expenditure and resale value of the asset were not
subject to inflation, what would happen to the NPV?
Which one of the following sets of adjustments will lead to the correct NPV being
calculated?
2.1.1 Taxation can have an important impact on project viability. If management are
implementing decisions that are shareholder wealth enhancing, they will focus on the
cash flows generated which are available for shareholders. Therefore, they will
evaluate the after-tax cash flows of a project.
2.1.2 Payments of tax, or reductions of tax payments, are cash flows and ought to be
considered in DCF analysis. Assumptions which may be stated in questions are as
follows.
(a) Tax is payable in the year following the one in which the taxable profits are
made. Thus, if a project increases taxable profits by $10,000 in year 2, there
will be a tax payment, assuming tax at 30%, of $3,000 in year 3.
(b) Net cash flows from a project should be considered as the taxable profits (not
just the taxable revenues) arising from the project.
2.2.1 Writing down allowance is used to reduce taxable profits, and the consequent
reduction in a tax payment should be treated as a cash saving from the acceptance
of a project.
2.2.2 EXAMPLE 3
ABC Ltd is considering a project which will require the purchase of a machine for
$1,000,000 at time zero. This machine will have a scrap value at the end of its four-
year life: this will be equal to its written-down value. Inland Revenue Department
(IRD) permits a 25% declining balance writing-down allowance on the machine
each year. Corporation tax, at a rate of 30% of taxable income, is payable. ABC
Ltd’s required rate of return is 12%. Operating cash flows, excluding depreciation,
and before taxation, are forecast to be:
Time (year) 1 2 3 4
$ $ $ $
Cash flows before tax 400,000 400,000 220,000 240,000
Note: All cash flows occur at year ends.
In order to calculate the NPV, first calculate the annual WDA. Note that each year
the WDA is equal to 25% of the asset value at the start of the year.
The next step is to derive the project’s incremental taxable income and to calculate
the tax payments.
Time (year) 1 2 3 4
$ $ $ $
Net income before WDA and tax 400,000 400,000 220,000 240,000
Less: WDA 250,000 187,500 140,625 105,469
Taxable profit 150,000 212,500 79,375 134,531
Tax payable at 30% 45,000 63,750 23,813 40,359
Time (year) 0 1 2 3 4
$ $ $ $ $
Incremental cash flow
(1,000,000) 400,000 400,000 220,000 240,000
before tax
Sale of machine 316,406
Tax payable 0 (45,000) (63,750) (23,813) (40,359)
Net cash flows (1,000,000) 355,000 336,250 196,187 516,047
Discount factor @12% 1.0000 0.8929 0.7972 0.7118 0.6355
Discounted cash flow (1,000,000) 316,980 268,059 139,646 327,948
NPV = $52,633
The assumption that machine can be sold at the end of the fourth year, for an
amount equal to the written-down value, may be unrealistic. It may turn out that the
machine is sold for the larger sum of $440,000. If this is the case, a balancing
charge will need to be made, because by the end of the third year IRD have already
permitted write-offs against taxable profit such that the machine is shown as having
a written-down value of $421,875. A year later its market value is found to be
$440,000. The balancing charge is equal to the sale value at Time 4 minus the
written-down value at Time 3, viz:
This result in a tax payment of $258,125 × 0.3 = $77,438 rather than $40,359.
Of course, the analyst does not have to wait until the actual sale of the asset to make
these modifications to a proposed project’s projected cash flows. It may be possible
to estimate a realistic scrap value at the outset.
An alternative scenario, where the scrap value is less than the Year 4 written-down
value, will require a balancing allowance. If the disposal value is $300,000 then the
machine cost the firm $700,000 ($1,000,000 – $300,000) but the tax written-down
allowances amount to only $683,594 ($1,000,000 – $316,406). The firm will
effectively be overcharged by IRD. In this case a balancing adjustment, amount to
$16,406 ($700,000 – $683,594), is made to reduce the tax payable.
$
Pre-tax cash flows 240,000
Less: Annual writing-down allowance (105,469)
Less: Balancing allowance (16,406)
II. Taxation
10. A company has 31 December as its accounting year end. On 1 January 2014 a new
machine costing $2,000,000 is purchased. The company expects to sell the machine on
31 December 2015 for $350,000.
The rate of corporation tax for the company is 30%. Tax-allowable depreciation is
obtained at 25% on the reducing balance basis, and a balancing allowance is available
on disposal of the asset. The company makes sufficient profits to obtain relief for
capital allowances as soon as they arise.
If the company’s cost of capital is 15% per annum, what is the present value of the
tax-allowable depreciation at 1 January 2014 (to the nearest thousand dollars)?
A $391,000
B $248,000
C $263,000
D $719,000
11. Jones Ltd plans to spend $90,000 on an item of capital equipment on 1 January 2012.
The expenditure is eligible for 25% tax-allowable depreciation, and Jones pays
corporation tax at 30%. Tax is paid at the end of the accounting period concerned. The
equipment will produce savings of $30,000 per annum for its expected useful life
deemed to be receivable every 31 December. The equipment will be sold for $25,000
on 31 December 2015. Jones has a 31 December year end and has a 10% post-tax cost
of capital.
What is the present value at 1 January 2012 of the tax savings that result from the
capital allowances?
A $13,170
B $15,826
C $16,018
D $19,827
12. A company receives a perpetuity of $20,000 per annum in arrears, and pays 30%
corporation tax 12 months after the end of the year to which the cash flows relate.
A $140,000
B $145,460
C $144,000
D $127,274
13. A project has an annual net cash inflow (in current terms) of $3 million, occurring at
the end of each year of the project's two year life. An investment of $3.5 million is
made at the outset. All cash inflows are subject to corporation tax of 30%, payable
when the cash is received. There is no tax allowable depreciation on the initial
investment. An average inflation rate of 5% per annum is expected to affect the
inflows of the project.
What is the expected net present value of the project (to the nearest $100)?
A $92,600
B $145,970
C $286,600
D $367,400
14. An asset costing $40,000 is expected to last for three years, after which is can be sold
for $16,000. The corporation tax rate is 30%, tax allowable depreciation at 25% is
available, and the cost of capital is 10%. Tax is payable at the end of each financial
year.
Capital expenditure occurs on the last day of a financial year, and the tax allowable
What is the cash flow in respect of tax allowable depreciation that will be used at time
2 of the net present value calculation?
A $1,688
B $2,250
C $5,624
D $7,500
Corporation tax is 30% and is paid half in the year and half in the following year, in
equal quarterly instalments. The instalments are in the 7th and 10th months of the year
in which the profit was earned and in the 1st and 4th months of the following year.
Tax allowable depreciation of 25% reducing balance will be claimed each year.
(Assume the asset is bought on the first day of the tax year and that the company's
other projects generate healthy profits.)
(Round all cash flows to the nearest $ and discount end of year cash flows.)
What is the present value of the cash flows that occur in the second year of the
project?
A 17,622
B 18,426
C 20,193
D 22,764
Uftin Co is a large company which is listed on a major stock market. The company has been
evaluating an investment proposal to manufacture Product K3J. The initial investment of
$1,800,000 will be payable at the start of the first year of operation. The following draft
evaluation has been prepared by a junior employee.
Year 1 2 3 4
Sales (units/year) 95,000 100,000 150,000 150,000
Selling price ($/unit) 25 25 26 27
Variable costs ($/unit) 11 12 12 13
(Note: The above selling prices and variable costs per unit have not been inflated.)
Required:
(a) Prepare a revised draft evaluation of the investment proposal and comment on its
financial acceptability. (11 marks)
(b) Explain any TWO revisions you have made to the draft evaluation in part (a) above.
(4 marks)
(15 marks)
(ACCA F9 Financial Management December 2014 Q4)
Year 1 2 3 4
Sales volume (units) 70,000 90,000 100,000 75,000
Average selling price (£/unit) 40 45 51 51
Average variable costs (£/unit) 30 28 27 27
Incremental cash fixed costs (£/year) 500,000 500,000 500,000 500,000
The above cost forecasts have been prepared on the basis of current prices and no account
has been taken of inflation of 4% per year on variable costs and 3% per year on fixed costs.
Working capital investment accounts for £200,000 of the proposed £1 million investment
Hendil uses a four-year evaluation period for capital investment purposes, but expects the
new product range to continue to sell for several years after the end of this period. Capital
investments are expected to pay back within two years on an undiscounted basis, and within
three years on a discounted basis.
The company pays tax on profits in the year in which liabilities arise at an annual rate of
30% and claims capital allowances on machinery on a 25% reducing balance basis.
Balancing allowances or charges are claimed only on the disposal of assets.
Required:
(a) Using Hendil plc’s current average cost of capital of 11%, calculate the net present
value of the proposed investment. (15 marks)
(b) Calculate, to the nearest month, the payback period and the discounted payback period
of the proposed investment. (4 marks)
(c) Discuss the acceptability of the proposed investment and explain ways in which your
net present value calculation could be improved. (6 marks)
(Total 25 marks)
(Amended ACCA Paper 2.4 Financial Management and Control December 2006 Q1)
3.3 EXAMPLE 4
A company expects sales for a new project to be $225,000 in the first year growing
at 5% pa. The project is expected to last for 4 years. Working capital equal to 10%
of annual sales is required and needs to be in place at the start of each year.
Calculate the working capital flows for incorporation into the NPV calculation.
Solution:
Calculate the absolute amounts of working capital needed over the project:
Year 0 1 2 3 4
$ $ $ $ $
Sales 225,000 236,250 248,063 260,466
Working capital (10% sales) 22,500 23,625 24,806 26,047
Work out the incremental investment required each year (remember that the full
investment is released at the end of the project):
Year 0 1 2 3 4
$ $ $ $ $
Working 23,625 – 24,806 – 26,047 –
22,500 23,625 24,806
Working capital investment (22,500) (1,125) (1,181) (1,241) 26,047
Year 1 100,000
Year 2 125,000
Year 3 105,000
Working capital is required to be in place at the start of each year equal to 10% of the
cash inflow for that year. The cost of capital is 10%.
A $ Nil
B $(30,036)
C $(2,735)
D $33,000
17. AW Co needs to have $100,000 working capital in place immediately for the start of a
2 year project. The amount will stay constant in real terms. Inflation is running at 10%
per annum, and AW Co’s money cost of capital is 12%.
What is the present value of the cash flows relating to working capital?
A $(21,260)
B $(20,300)
C $(108,730)
D $(4,090)
18. A new project is expected to generate sales of 55,000 units per year. The selling price
is expected to be $3.50 per unit in the first year, growing at 6% pa. The project is
expected to last for three years. Working capital equal to 12% of annual sales is
required and needs to be in place at the start of each year.
What is the cash flow in respect of working capital that will be used at time 2 of the
net present value calculation?
A $(25,955)
B $(24,486)
C $(1,386)
D $(1,469)
Year 0 1 2 3 4
$000 $000 $000 $000 $000
Sales X X X
Costs (X) (X) (X)
Operating cash flows X X X
Taxation (X) (X) (X)
Tax benefit of CAs X X X
Year 1 2 3 4
Production and sales (units/year) 35,000 53,000 75,000 36,000
The selling price of product P (in current price terms) will be $20 per unit, while the variable
cost of the product (in current price terms) will be $12 per unit. Selling price inflation is
expected to be 4% per year and variable cost inflation is expected to be 5% per year. No
increase in existing fixed costs is expected since SC Co has spare capacity in both space and
labour terms.
Producing and selling product P will call for increased investment in working capital.
Analysis of historical levels of working capital within SC Co indicates that at the start of
each year, investment in working capital for product P will need to be 7% of sales revenue
for that year.
SC Co pays tax of 30% per year in the year in which the taxable profit occurs. Liability to
tax is reduced by capital allowances on machinery (tax-allowable depreciation), which SC
Co can claim on a straight-line basis over the four-year life of the proposed investment. The
new machine is expected to have no scrap value at the end of the four-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment
appraisal purposes.
Required:
(a) Calculate the net present value of the proposed investment in product P. (12 marks)
(b) Calculate the internal rate of return of the proposed investment in product P.
(3 marks)
(c) Advise on the acceptability of the proposed investment in product P and discuss the
limitations of the evaluations you have carried out. (5 marks)
(d) Discuss how the net present value method of investment appraisal contributes towards
the objective of maximising the wealth of shareholders. (5 marks)
(Total 25 marks)
(ACCA F9 Financial Management June 2008 Q4)
Year 1 2 3 4
Sales and production (units) 150,000 70,000 60,000 60,000
Selling price (£ per game) £25 £24 £23 £22
Advertising costs to stimulate demand are expected to be £650,000 in the first year of
production and £100,000 in the second year of production. No advertising costs are expected
in the third and fourth years of production. Fixed costs represent incremental cash fixed
production overheads. ‘Fingo’ will be produced on a new production machine costing
£800,000. Although this production machine is expected to have a useful life of up to ten
years, government legislation allows Charm plc to claim the capital cost of the machine
against the manufacture of a single product. Capital allowances will therefore be claimed on a
straight-line basis over four years.
Charm plc pays tax on profit at a rate of 30% per year and tax liabilities are settled in the year
in which they arise. Charm plc uses an after-tax discount rate of 10% when appraising new
capital investments. Ignore inflation.
Required:
(a) Calculate the net present value of the proposed investment and comment on your
findings. (11 marks)
(b) Calculate the internal rate of return of the proposed investment and comment on your
findings. (5 marks)
(c) Discuss the reasons why the net present value investment appraisal method is preferred
to other investment appraisal methods such as payback, return on capital employed and
internal rate of return. (9 marks)
(Total 25 marks)
(ACCA Paper 2.4 Financial Management and Control June 2006 Q5)
Year 1 2 3 4
Demand (units) 35,000 40,000 50,000 25,000
The selling price for Product T is expected to be $12.00 per unit and the variable cost of
production is expected to be $7.80 per unit. Incremental annual fixed production overheads of
$25,000 per year will be incurred. Selling price and costs are all in current price terms.
Other information:
Trecor Co has a real cost of capital of 5.7% and pays tax at an annual rate of 30% one year in
arrears. It can claim capital allowances on a 25% reducing balance basis. General inflation is
expected to be 5% per year.
Required:
(a) Calculate the net present value of buying the new machine and comment on your
findings (work to the nearest $1,000). (13 marks)
(b) Calculate the before-tax return on capital employed (accounting rate of return) based on
the average investment and comment on your findings. (5 marks)
(c) Discuss the strengths and weaknesses of internal rate of return in appraising capital
investments. (7 marks)
(ACCA F9 Financial Management Pilot Paper Q4)
Year 1 2 3 4
Demand (units) 1.4 million 1.5 million 1.6 million 1.7 million
Existing production capacity for Quago is limited to one million kilograms per year and the
new machine would only be used for demand additional to this.
The current selling price of Quago is $8.00 per kilogram and the variable cost of materials is
$5.00 per kilogram. Other variable costs of production are $1.90 per kilogram. Fixed costs of
production associated with the new machine would be $240,000 in the first year of
production, increasing by $20,000 per year in each subsequent year of operation.
Duo Co pays tax one year in arrears at an annual rate of 30% and can claim capital allowances
(tax-allowable depreciation) on a 25% reducing balance basis. A balancing allowance is
claimed in the final year of operation.
Duo Co uses its after-tax weighted average cost of capital when appraising investment
projects. It has a cost of equity of 11% and a before-tax cost of debt of 8·6%. The long-term
finance of the company, on a market-value basis, consists of 80% equity and 20% debt.
Required:
(a) Calculate the net present value of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest $1,000). (13 marks)
(b) Calculate the internal rate of return of buying the new machine and advise on the
acceptability of the proposed purchase (work to the nearest $1,000).
(4 marks)
(c) Explain the difference between risk and uncertainty in the context of investment
appraisal, and describe how sensitivity analysis and probability analysis can be used to
incorporate risk into the investment appraisal process. (8 marks)
(Total 25 marks)
(ACCA F9 Financial Management December 2007 Q2)
The research and development division has prepared the following demand forecast as a result
of its test marketing trials. The forecast reflects expected technological change and its effect
on the anticipated life-cycle of Product W33.
Year 1 2 3 4
Demand (units) 60,000 70,000 120,000 45,000
It is expected that all units of Product W33 produced will be sold, in line with the company’s
policy of keeping no inventory of finished goods. No terminal value or machinery scrap value
is expected at the end of four years, when production of Product W33 is planned to end. For
investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year
and a target return on capital employed of 30% per year. Ignore taxation.
Required:
(a) Identify and explain the key stages in the capital investment decision-making process,
and the role of investment appraisal in this process. (7 marks)
(b) Calculate the following values for the investment proposal:
(i) net present value;
(ii) internal rate of return;