this is a lecture from open tuition to benefit from the lecture you should download the free lecture notes from open tuition com alright we're looking at chapter 8 of the free lecture notes and go through the relevant cash flows at the discounted cash flow how we arrived at cash flows in the last lecture I dealt with working capital in this lecture tax and as I said almost every long form section see question in their growth 9 discounted cash flow almost every time limit tax is relevant and the reason it's relevant as I said at the end of the last lecture if we're doing a new project and earning more from the project then the company's profits overall are going to increase and the company will pay extra tax as a result and of course tax is a cash flow now the touch you need is limited it mean this isn't a tax exempt but you do need a little bit of knowledge of tax explained as we go through what the rules are for f9 which if you have already taken paper sinks should be no problem at all if you haven't taken pick up sinks then make sure you unhappy with the rules as I go through them and do learn them have a look with me at example 4 and I'll use this to explain how we deal with the tax and we get the figures a company has a year-end of 31st December each year it's considering the purchase of a new machine on the 1st of January 2003 at a cost of 10000 and the machine is expected to generate net operating cash flows 5,000 during the first year 7 during ascent and 8 during the third we're going to sell the machine at the end of the third year over 6,000 an additional working capital a thousand will be required at the start of the project so so far just like what we had previous in the previous lecture there will be with different numbers obviously the extra bit though the corporation or company tax payable at 30 percent it's payable one year in arrears one year late a capital allowances are available capital allowances another word is tax allowable depreciation then available at 25 percent on the reducing balance basis and the cost of capital is ten percent so we are going to have previously set up the cash flows each year and this time we will actually discount we told the cost of companies ten percent now before I go through this question just one thing I must explain which affects the way we set it out in real life again with you've done f6 ago haven't the way tax is calculated if I told you making up a few figures before we look at example for a full suppose I told you the net operating cash flow as I say making up figures suppose the city was a thousand well when they calculate tax the calculate tax on the profit and the profit will actually be lower because of tax allowable depreciation which is no cash flow but for tax purposes you're allowed to subtract it which say less capital allowances and again I'm making her figures suppose they were 200 and that would give a taxable profit of 800 they calculate tax on the taxable profit and so if the taxes let's say 30% the tax would be to 14 however although that's fine when we remember we actually want the cash flows on our statement before we were to be able to discount and what are the cash flows well there is an inflow of a thousand the net operating cash flow now coming allowances is depreciation that is not a cash flow even though it was needed in our tax workings the only other cash flow is the tanks of 240 and so the net cash flow would be 760 now I hope that makes sense now matter itself isn't difficult and that's the way we calculate the tax you know paper have sinks but as you'll see when we do example 4 it can actually get a bit messy to do it that way the exam in f9 them and what we always doing at 9 which you'll see why this actually makes it easier when we setting up but you know time 0 time 1 time 2 and so on we say well the net operating cash flow is a thousand and we say well forgetting the depreciation for the moment what would the tax be on a thousand if there was no tax on depreciation the tax of 30% on that would be 300 however we already know from what we did a minute ago that the tax we're not actually going to pay through English at all because there is tax allowable depreciation capital allowances and we show separately the tax saving on the capital allowances how much did the capital allowances the textile depreciation how much tax it is saying this well if the capital allowances were what were they 200 the actual taxable profit is 200 lower therefore the tax on be lower at 30% 60 it's a saving the actual tax payable is 240 it's 300 based on the net operating flows but then the saving of 60 from capital balances and the end result of course the net something's not only my pen here the net cash flow is 12 14 don't know it isn't stupid on me a thousand said it's 760 the same as there now you may be wondering why I do it this way you'll see when we do this full example example for why it's much more efficient you could do it that way but it needs more words there isn't easier to go wrong and as you'll see it's easier to lose monarchs much more efficient is to do it this way work out me and get the net operating cash flows and work out the tax ignoring allowances separately the tax saving on the ounces all right sorry about that diversion but now let's look at example for getting habits as soon as you see one of these long form questions check how many years is to project continuing and here what we suddenly machine the end of the third year so the three years to setup your columns not one two three I always leave a bigger space because when there's tax you're quite likely as you'll see to need an extra year first of all go for our operating flows as you saw in the previous that you wanna get working capital quite likely you'll have to work out these figures revenues us costs but here we told the net operating flow five thousand in the first year seven in the second eight in the third easy having got the net operating flow that cash profit work out their tax on the operating flows here is a thirty percent so first year is five thousand the tax on eight thirty percent of five thousand one thousand five hundred however check the timing and I can't remember what's in there f6 what the time code is for paying tax but in paper of nine are you told either you'll be told tax is payable immediately and having been payable immediately thirty percent to five thousand fifteen hundred at time one o as in this question it's one year in arrears you pay the tax one year late so the tax 30% of 5,000 is 1,500 but it'll be payable one year later at time and two family 7,000 at time to tax 30% 2,100 but payable one year later wandering areas time and three and finally a thousand thirty percent two thousand four hundred but it's payable one year later time at four so again so if I'm nice and easy obviously you'll be told the tax rate it's in the tax exams so usually have a rate you're given and as I say always its annual design a payable immediately on should be one two three four as here one year in arrears well that makes sense and incidentally when these questions are being marked the long form questions each line is marked separately you know depending how easy it is it may just be half a market maybe one market may be too much but each lines marked separately and so whatever is coming later I think those two are desperately easy marks sorry okay let's carry on what other throws the next thing to look at is the capital flows and by that I mean the initial cost of the machine and where is it second line it costs ten thousand at time zero and it's going to be scrapped at the end of the project three years time the sale proceeds the scrap we're told we intend to save for six thousand so an inflow of 6,000 at time three again another easy half-mile mark or whatever next though we need to look at the tax saving will be on the capital allowances if you remember from that little illustration I gave ya we've calculated the tax as though there were no capital allowances the actual tax will be lower we'll save tax on these allowances now here you always need separate workings and watch how we do it especially if you haven't done paper f6 if there's the capital analysis at 25 percent per annum on a reducing balance basis and you'll always be told the rule we told what percent and what methods used and so let's do it the original cost of the machine was ten thousand and so the first capital allowance computation will be 25 percent of ten thousand which is two thousand five hundred it's reducing balance depreciation you know get you should I be about that from a paper of three but it brings the tax value down to seven thousand five hundred remember what we're after is the tax will save as a result of capital analysis and so if the capital allowance is 2,500 will save thirty percent of that which is 750 and before I go any further when will we make that tax saving the first couple IRS they always calculate capital allowances at the end of the accounting period and so we bought the Machine craps on the 1st of January capital ounces would be calculated the 31st of December one year's time however because of the one-year delay in takes although they'll calculate enhancing one year's time tax in here is again arrears will actually make the saving one year later in two years time will save tax of 750 at time two it's a tax saving appreciate that sir it's a cash inflow and I fact you will see in a later chapter there's one specific type of problem where the timing can get a bit messy I'll deal with that when we come to it but in a standard appraisal question like this one then basically the first tax saving couple out sailing will be the same period as the first tax on the operating profits so anything here in arrears these are perfect time to if you were told taxes payable immediately they would both be at time one however let's continue that was the first computation the second one it's reducing balance and so 25% of 7,500 Nordia 25% of Scylla 500 is one eight seven five bringing the tax value down to five six to five how is the tax saving we're after so 30% will save tax a 560 2.5 had never work in though sentence ever round doesn't really go five six three five six two but we're saving the five six three one year later at time three well that's fine reducing balance should be no problem you know we can't win that percentage here however whenever my time the ff6 I'm okay we have six you have a pool and things so we can't come with that here you do twenty five percent each year until the final year of the year of sale I hear it when we got machine for three years so the final year is the third year and in the last year we do not calculate twenty five percent we in the final year we effectively get all the remaining announces in the final year we simply deduct the sale proceeds which here a six thousand and whatever is left whatever's left here is what three seven five is either what we call a balancing allowance or a balance in charge and what it is is this you've seemed total and sorry if you've done f6 sort of be aware of this but in total we bought the machine for ten we sold it for six and therefore in total we will get four thousand allowances each year it's 25% and so how many allowances that we had two and a half thousand 1875 we've had for 375 I mean are they entitled to four thousand over the life of this machine and so the final year depending on which way round it is they either give you a bit more allowance or take away allowances to make sure what the total is correct here we've had 375 more than we're entitled to and so we have what we call a balancing charge and we'll have to pay tax on that three seven five and so the via tax payment extra payment or an outflow 375 times point three 113 now I can be a year later tie for I'll go back to the cash flow label in a moment but do see what I've done every year until the last is 29% but a Todd takes me to time that's just speed let me calculate it but the final year you subtract the sale proceeds here the sale proceeds are higher than the tax value of five six twenty five so there's a charge in 30 percent of the extra if on the other hand suppose the sale proceeds had only been five thousand well we've not had enough allowances the difference of is 625 and that would be assailing it would be a balancing allowance if there's no scrap value if there's no mention of a scrap value then there isn't one in which case it's cereal so the scrap groceries were zero the difference is 5 6 to 5 well that again would be a balancing allowance we've done differences and so it will be another saving so think about batting is there a way around here again the proceeds were higher than the tax value so instead of saving tax will be paying extra tax again the 30% so let's go finish off the thing 1 1 3 we change the color back 1 1 3 it was a balancing charge and so as a cash outflow finally though there is working capital well I've already been through the rules on working capital with you this is an easy 1,000 required at the start of that seed however because working capital is things like buying extra inventory there is no tax effect on working capital that's why I always leave it to the end so the working capital was it say a thousand required at the start of the project here no mention any extra during the project we assume that we get it back oh when capital comes back at the end of the project in 3 years time there we are so what are the net cash flows xi at outflow at time zero inflow of 5000 of time Worman at time to seven thousand minus fifteen hundred plus 756 250 at time three an inflow of 13 one six three and finally a time for an outflow of two five one three and this one we are given the cost of can be bullets and so I am going to discount what is it at ten percent and the discount factors for one year point nine oops point 909 for two years point eight two six four three years 0.75 one and finally for four years point six eight three well we've we've spent enough time on the discounting on the previous chapter and I didn't say this really has to be automatic and fast make some space so the present values eleven thousand five thousand times point nine nine four five oops four five four five sixteen fifty times my take two sinks five one six three thirteen one six three times point zero five one nine eight eight five and finally two five one three times 1/16 two three one seven one six in negative and so finally the net present value is what 4 5 4 5 +5 1 6 3 9 8 8 5 -1 7 1 6 and minus 11,000 it's + 6 8 7 7 and of course don't just leave it at that I'm a litany alpha mark but you must state as a result will we accept or reject well here because it's positive as a surplus we will therefore accept the project so there we are with tax obviously takes a bit more time but bear in mind what I've said the way these are marked now when it's a long fall question section see the final answer gets virtually no marks at all the marks are for the workings and each bit of this will be marked separately so for heaven's sakes set up your workings nicely so the market can see what you're doing you know if you have made a mistake if it's just obviously a silly arithmetic mistake that's hardly was anything marks at all but he can only see that if you've shown your workings properly but the nice thing about dealing with tucks this way you see the operator flossing were a joke easy half a mark you just give me the question the tax on them alpha mark maybe what marks there was some arithmetic to do but easy the cost and the scrap again you cannot miss read a question but otherwise straight from the question alpha mark tax saving on the couple ounces takes time you know you show your workings so that again you can still get marks if you were doing it the right way even if something went wrong you know make Miss America metric mistake on the first allowance on the first allowance and the others are all wrong but you still get almost all the marks if it's clear you're doing it the right way but also if something does go wrong there you're still getting the marks for the other mates you know whereas if you're doing it all together a mistake on one bit can make it impossible to check the other bits and remember you only need 50% bill to pass it and of course the discounting you'll get marks for discounting half a mark 1 mark the discounting correctly even if all your cash flows were wrong you don't lose much twice so providing your cash flows have been discounted correctly you'll get the marks so although you'll see when you come to practice for once and in fact the next lecture we're going to bring in which makes more complication it's hard to get everything perfectly right in the neck so but if you're sensible and if you set it out nicely doesn't look nice anymore but it did what I started if you set it up nice thing that can follow your workings I say again it may be hard to get full marks MIDI back so you bound to make some mistakes but it should be very easy to get your heart knocks and to pass it and one final thing in case anybody's wondering to do with tanks is what can is that the operating flow in the first ship suppose it was a lower suppose in the first year it was only as I say two thousand instead of five everything else was the same he wouldn't mean the tanks and the operating flows in the first year was six hundred thirty percent of two thousand everything else was to the same but what worries some people is if the cash flows are two thousand and if the chemical imbalances in the first year ah if you look back there were two thousand five hundred it means who all they're making a tax loss well even if you don't pay perhaps six and you know how to deal with losses you cannot be expected to deal with your losses in paper f9 we always assume that the company is already making lots of profit and is already paying lots of tanks and so if this project if it happened to make a loss in the first together it's not a real loss it will simply reduce the existing profit which will mean the total tax payable by the company is the lower will be a tax saving you'll never have to deal with losses and therefore nothing I've said it changes the tax on the operating flows thirty percent of the operating flown capital allowances the workings as we have before you never needed this exam to worry about losses or for that matter any other taxes we only examine on dat a sales tax or any of the taxes it's just being able to deal with company tax in this sort of question okay well we tell me working capital with double tax there's one last problem which again appears in virtually every Section C long-form question investment appraisal and that's inflation so in the next lecture we do with inflation and then we've got everything in this sort of 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