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Business Finance > Lecture 7 - Investment appraisal- practical matters (2) > Flashcards

Lecture 7 - Investment appraisal- practical matters (2) Flashcards

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1
Q

What is the main focus of the slide?

A

The slide focuses on the general principles of taxation in project appraisal, particularly the different types of cash flows and their tax treatment.

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2
Q

What are the two main categories of cash flows in project appraisal?

A

Capital Investment and Operational.

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3
Q

What is a Capital Investment?

A

Any cash flow related to the purchase or sale of long-term assets like equipment and facilities.

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4
Q

What does a Capital Investment involve?

A

Converting wealth from one form to another, with some capital investments losing value over time (depreciation), while others may not.

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5
Q

Give an example of a depreciating capital investment.

A

Investing in a car, which loses value with use and age.

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6
Q

Give an example of a non-depreciating capital investment.

A

Investing in a block of gold, which typically has no predictable loss or gain in value.

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7
Q

What is an Operational cash flow?

A

Any cash flow associated with the project’s process, including sales income and various costs such as materials, storage, and wages.

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8
Q

What are some examples of costs included in Operational cash flows?

A

Costs for materials, storage, distribution, maintenance, wages, heating, and facilities rental.

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9
Q

Why is it important to split cash flows into Capital Investment and Operational categories?

A

Because they are treated differently in tax calculations.

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10
Q

How are Capital Investment cash flows treated in tax calculations?

A

They do not enter the tax calculation directly but may be subject to depreciation or capital allowances.

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11
Q

How are Non-Capital Investment (Operational) cash flows treated in tax calculations?

A

They are used to produce a net cash flow, which is then taxed.

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12
Q

What does the slide suggest about the relationship between operational cash flows and taxable income?

A

Operational cash flows contribute directly to the net cash flow, which is subject to taxation

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13
Q

What is the main focus of taxation in project appraisal?

A

The focus is on understanding the different types of cash flows and how they are treated for tax purposes in project appraisal.

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14
Q

What are the two main categories of cash flows in project appraisal?

A

Capital Investment and Operational.

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15
Q

How is Capital Investment defined in project appraisal?

A

It refers to any cash flow related to the purchase or sale of long-term assets like equipment and facilities.

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16
Q

What does a Capital Investment involve in terms of wealth conversion?

A

It involves converting wealth from one form to another, where some investments may depreciate over time while others may not.

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17
Q

What is an example of a depreciating capital investment?

A

Investing in a car, which loses value with use and age.

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18
Q

Can you provide an example of a capital investment that does not typically depreciate?

A

Investing in a block of gold, which usually does not have a predictable loss or gain in value.

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19
Q

What constitutes Operational cash flow in a project?

A

Any cash flow associated with the project’s process, including sales income and various costs such as materials, storage, and wages.

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20
Q

What are some specific costs included under Operational cash flows?

A

Costs for materials, storage, distribution, maintenance, wages, heating, and facilities rental.

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21
Q

Why is it important to distinguish between Capital Investment and Operational cash flows?

A

Because they have different implications for tax calculations.

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22
Q

How are Capital Investment cash flows treated for tax purposes?

A

They do not directly enter the tax calculation but may be subject to depreciation or capital allowances.

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23
Q

How are Operational (Non-Capital Investment) cash flows treated for tax purposes?

A

They contribute to the net cash flow, which is then subject to taxation.

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24
Q

What role do operational cash flows play in determining taxable income?

A

Operational cash flows directly affect the net cash flow, which is used to determine taxable income.

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25
Q

Why are investment cash flows only indirectly involved in tax calculations?

A

Investment cash flows are used to calculate the tax allowance, which then reduces the taxable income, rather than being taxed directly.

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26
Q

What is a tax allowance?

A

A tax allowance is an amount of income that is exempt from taxation. It reduces the taxable income, thereby lowering the amount of tax owed.

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27
Q

How do companies and individuals benefit from a tax allowance?

A

A tax allowance reduces their taxable income, meaning they pay less tax on their earnings above the allowance threshold.

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28
Q

What is the correct formula to calculate the taxable amount each year?

A

Income - Expenses - Tax Allowance = Taxable Amount

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29
Q

How is the tax to pay calculated after determining the taxable amount?

A

The taxable amount is multiplied by the tax rate: (Tax Rate) × (Taxable Amount) = Tax to Pay

30
Q

How is the tax saved by the allowance calculated?

A

Tax Saved by the Allowance = (Tax Rate) × (Tax Allowance)

31
Q

What is the significance of interest payments in tax calculations?

A

Interest payments are considered as expenses, which reduce the taxable income, leading to potentially lower taxes.

32
Q

How do interest payments affect the taxable amount?

A

They reduce the taxable amount since they are subtracted as part of the expenses, lowering the overall tax liability.

33
Q

What is the benefit of counting interest payments as an expense?

A

Counting interest payments as an expense reduces the taxable income, which decreases the total tax owed.

34
Q

What is a capital allowance?

A

A capital allowance is a form of tax allowance that provides tax relief on the loss of value of certain investments, incentivizing business investment.

35
Q

Why are capital allowances important for businesses?

A

They reduce taxable income by allowing businesses to deduct the depreciation of assets, effectively lowering the amount of tax they owe.

36
Q

How is a capital allowance calculated?

A

It is calculated based on the value of investment cash flows and the real loss of value (depreciation) of capital assets used in business processes.

37
Q

What does investment cash flow represent in the context of capital allowance?

A

Investment cash flow shows the initial investment in assets and the subsequent loss of value over time due to use or obsolescence.

38
Q

How do tax authorities treat the loss in value of assets for tax purposes?

A

The loss in value (depreciation) is treated as if it were a real cash outflow, allowing it to be deducted from taxable income.

39
Q

What is depreciation in accounting, and how is it related to capital allowance?

A

Depreciation is the accounting process of allocating the cost of a tangible asset over its useful life, and it forms the basis for calculating capital allowances for tax purposes.

40
Q

Where does capital allowance appear in cash flow analysis?

A

Capital allowance appears only in the tax allowance calculation and is not considered as an actual cash flow in other parts of project appraisal.

41
Q

Why do capital allowances incentivize investment?

A

They reduce the effective cost of investing in capital assets by allowing businesses to deduct the loss in value of these assets from their taxable income.

42
Q

What is a capital allowance for a year?

A

It is the fall in value of eligible assets over that year, which can be claimed as a tax deduction.

43
Q

Which assets are generally allowed capital allowances?

A

Machinery is generally allowed, while land or property is typically not allowed.

44
Q

How is the fall in value of assets calculated for capital allowances?

A

It is calculated using methods prescribed by the tax authority, such as HM Revenue and Customs (HMRC) in the UK.

45
Q

What is the straight line method of calculating depreciation?

A

It spreads the fall in value of an asset evenly over its useful life. It was used in the UK for long-life assets like industrial and agricultural buildings, but is now phased out for these assets.

46
Q

Is the straight line method still used anywhere?

A

Yes, it is still used by some non-UK tax authorities, such as in Germany.

47
Q

What is the reducing (declining) balance method?

A

It calculates depreciation as a fixed percentage of the asset’s remaining value each year, resulting in higher depreciation in earlier years.

48
Q

Are capital allowances available for all types of assets?

A

No, only certain assets like machinery are eligible, while land and property are generally not.

49
Q

Where can you find the capital allowance tax rules for the UK?

A

The capital allowance tax rules for the UK can be obtained from HMRC’s official website.

50
Q

What does “clawback” mean in the context of capital allowances?

A

Clawback refers to the repayment of excess tax savings previously claimed through capital allowances when an asset’s actual sale price is higher than expected. This happens because the company effectively claimed too much in allowances, and must repay the over-saved tax amount to the tax authorities.

51
Q

What is residual value (WDV) in the context of capital allowances?

A

The residual value, or Written-Down Value (WDV), is the remaining value of an asset after accounting for depreciation.

52
Q

How does the residual value (WDV) change under the reducing balance method?

A

The residual value drops by 20% each year, with depreciation calculated on the remaining value of the asset, not the original purchase price.

53
Q

What happens to the residual value when an asset is sold?

A

The residual value is reset to the sale value, which affects the final capital allowance calculation and can trigger a clawback if the sale price is higher than expected.

54
Q

Why is the reset of residual value at sale important?

A

It adjusts the residual value to reflect the actual sale price, ensuring that capital allowances are accurately calculated. A higher sale price can lead to a clawback.

55
Q

What is the formula provided for the sum of capital allowance over the asset’s lifetime?

A

The formula is: Sum of capital allowance over lifetime = Capital investment − Scrap value. Scrap value is the income from selling the asset.

56
Q

What does the sum of capital allowance over a lifetime represent?

A

It represents the total depreciation claimed as capital allowance, which should equal the original investment cost minus the final sale value of the asset.

57
Q

How can the sale of an asset impact the tax allowance?

A

The sale might reduce the tax allowance, and if the sale price is higher than expected, a clawback of previously claimed allowances may be required.

58
Q

Why is it crucial to adjust the residual value to the actual sale price?

A

Adjusting the residual value ensures that the depreciation reflects the true loss in value over the asset’s lifetime and prevents over-claiming of allowances.

59
Q

What is working capital?

A

Working capital is the cash required by a project or business to cover short-term funding needs, managing the timing differences between payments to suppliers and receipts from customers.

60
Q

Why is working capital important in retail?

A

In retail, working capital is needed to bridge the time gap between paying suppliers for goods received and getting paid by customers for goods sold.

61
Q

Why is working capital important in manufacturing?

A

In manufacturing, working capital is necessary to cover the time gap between purchasing raw materials and receiving payment for the final product sold.

62
Q

What is the formula for calculating working capital?

A

The formula for working capital is: Working Capital = Current Assets - Current Liabilities.

63
Q

What are current assets (CAs)?

A

Current assets are assets that can be converted into cash within a short period, such as cash, unused raw materials, finished goods, and customers’ unpaid bills (accounts receivable).

64
Q

What are current liabilities (CLs)?

A

Current liabilities are obligations that the company needs to pay off within a short period, such as bills the company has not yet paid (accounts payable).

65
Q

How does working capital help a business operate smoothly?

A

Working capital ensures that a business can cover its short-term obligations and continue operating smoothly by managing the timing differences between cash outflows and inflows.

66
Q

What is the impact of poor working capital management?

A

Poor working capital management can lead to liquidity issues, where a business may struggle to meet its short-term obligations, potentially disrupting operations.

67
Q

Is working capital consumed by the project?

A

No, working capital is not consumed by the project. It can be recovered when the project ends.

68
Q

Why is working capital counted as a capital investment cash flow?

A

Because it is not consumed and can be recovered at the end of the project, unlike operational cash flows which are spent and not recoverable.

69
Q

Does working capital attract capital allowances?

A

No, working capital does not attract capital allowances because it is not a depreciable asset.

70
Q

Does working capital play a role in tax calculations?

A

No, working capital plays no part in tax calculations since it does not attract capital allowances.

71
Q

What is the recommended approach for handling working capital in project appraisal?

A

The recommended approach involves two cash flows at the end of each year: recovering the amount used during that year, and injecting the amount required for the following year.

72
Q

Why is working capital not considered an operational cash flow?

A

Working capital is not considered an operational cash flow because it represents short-term assets that can be recovered, rather than expenses that are used up in operations.

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