Chapter 4 - Investment Appraisal - Further Aspects Of Discounted Cash Flows

Question 0

Methods of dealing with inflation

Answer 0

Real method:
1. Do not inflate the cash flows. Leave them in real terms i.e. In today’s (T0) prices - real flows.

2. Discount using the real rate.

Money/ Nominal method:
1. Inflate each cash flow by the inflation rate i.e. Convert it to a money flow.

2. Discount using the money rate.

Question 1

The impact of inflation on interest rates

Answer 1

Inflation is a general increase in prices leading to a general decline in the real value of money.

The fund providers will require a return made up of two elements:

1. Real return for the use of their funds.
2. Additional return to compensate for inflation.

The overall required return is called the money or nominal rate of return.

The real and money (nominal) returns are linked by the formula:

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

i = money rate
r = real rate
h = inflation

Question 2

Specific and general inflation rates

Answer 2

When to use the money or real method?

1. Is there one rate of inflation and no tax in the question?
   If no, then use Money/ Nominal method e.g. Wages 3%, materials 4%, general inflation 5%.
   Inflate cash flows to money terms.
   Money method

If yes, then 2. Are the cash flows in real or money terms?
If in real terms, then use Real method.
If in money terms, then use Money method.

If a question contains both tax and inflation, then use the Money method.

Question 3

The impact of taxation on cash flows

Answer 3

1. Operating cash inflows will be taxed at the corporation tax rate.
2. Operating cash outflows will be tax deductible and tax relief at the corporation tax rate.
3. Investment spending attracts capital allowances or WDAs which get tax relief.
4. The company is earning net taxable profits overall.
5. Tax is paid one year after the related operating cash flow is earned unless told otherwise.

Question 4

Capital allowances/ WDAs

Answer 4

A business may not deduct the cost of an asset from its profits as depreciation instead the cost must be deducted from taxable profits in the form of capital allowances or WDAs.

1. WDAs are calculated based on written down value of the assets (either reducing balance or straight line basis)
2. The total WDAs over the life of an asset equate to the fall in value over the period.
3. WDAs are claimed as early as possible.
4. WDAs are given for every year of ownership except the year of disposal.
5. In the year of scrap or sale, a balancing allowance (BA) or balancing change (BC) arises.

                                                                                 $ Original cost of asset                                                   x Cumulative capital allowances claimed                     (x)
                                                                                 --- Written down value of the asset                                  x Disposal value of the asset                                         (x)
                                                                                 --- Balancing allowance or balancing charge                  X
                                                                                 ---

Question 5

Incorporating working capital

Answer 5

The treatment of working capitals is as follows:-

1. Initial investment is a cost at the start of the project.
2. If the investment is increased, the increase is a relevant cash outflow.
3. At the end of the project, all the working capital is released and treated as a cash inflow.

To calculate the working capital cash flows:-

1. Calculate the absolute amounts of working capital needed in each period.
2. Work out the incremental cash flows required each year.

Question 6

Long NPV questions Proforma

Answer 6

Year 0 1 2 3

1. Net trading revenue.
   The inflows and outflows from trading (sales - operating cash flows).
   Inflated where necessary.
2. Tax payable.
   The net trading revenue x tax rate (Normally delayed by 1 year).
   Calculated as normal on the money flows.
3. Investment.
   Shouldn’t need inflating.
4. Residual/ Scrap value.
   May need inflating but usually in money terms.
5. Tax relief on WDAs.
   Calculated as normal.
6. Working capital flows.
   Calculate using money figures.