# CMA Study Group

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## Capital Budgeting

• #### 1.  Capital Budgeting

Posted 05-24-2022 01:09 PM
Hi...i have a quick doubt in question 2.6 from CMA support packages:

Right-Way Stores is a chain of home improvement stores with 150 locations. Right-Way has
identified an attractive site for a new store and Jim Smith, Director of Financial Planning, has been
asked to prepare an analysis and make a recommendation for or against opening this proposed new
store.
In preparing his analysis, Smith has determined that the land at the proposed site will cost \$500,000
and the new store will cost \$3.5 million to build. The building contractor requires full payment at
the start of construction, and it will take one year to build the store. Right-Way will finance the
purchase of the land and construction of the new building with a 40-year mortgage. The mortgage
payment will be \$118,000 payable annually at year end. Fixtures for the store are estimated to cost
\$100,000 and will be expensed. Inventory to stock the store is estimated to cost \$100,000.
Concerned about the possibility of rising prices, the company expects to purchase the fixtures and
inventory at the start of construction. Advertising for the grand opening will be \$50,000, paid to the
advertising agency on retainer at the start of construction. The new store will begin operations one
year after the start of construction.
Right-Way will depreciate the building over 20 years on a straight-line basis, and is subject to a 35%
tax rate. Right-Way uses a 12% hurdle rate to evaluate projects. The company expects to earn after-
tax operating income from the new store of \$1,200,000 per year.
REQUIRED:
1. What is Right-Way's total initial cash outflow? Show your calculations.
Solution:
500000 + 3500000 + 100000 + 100000 + (50000*(1-.35)) = \$4232500
Why they have considered tax effect for marketing expenses alone that too in initial cash outflow?

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Shrihari Jayakumar
Other
Chennai TN
India
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• #### 2.  RE: Capital Budgeting

Posted 05-25-2022 01:48 AM
I think, based on the IRS rule, fixtures must be capitalized. Inventory is not an expense that can be deducted as a tax shield item. Land and building are easy to understand. All these items are assets and listed on the balance sheet. The only expense that can be deducted is Advertisement as an Operating expense. Please correct me if I am wrong.

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Duc Truong
Accountant
Westminster CA
United States
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• #### 3.  RE: Capital Budgeting

Posted 05-25-2022 03:48 AM
Hi
See here it is mentioned specifically that the marketing exp is paid at the beginning of the year. So definitely it will be the part of initial cash outflow and thst too after tax..

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VIMAL RAJ CHAKKINGAL
Student
India
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• #### 4.  RE: Capital Budgeting

Posted 05-25-2022 04:49 AM
Hi Vimal.
I agree that the marketing expense can be considered at the initial cash flow since it is given in question but how come we will charge tax for the expense and that too tax effect will be attract only at the end of the period right?

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Shrihari Jayakumar
Other
Chennai TN
India
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• #### 5.  RE: Capital Budgeting

Posted 05-25-2022 05:00 AM
See Normally in the initial investments under CB we will include
1. The total intital investment required
2. The initial WC investment
3. Any  gain or loss on the sale of the asset at the beginning of the period.

And in CB normally we use to consider CF After tax and depreciation and not cash before taxand depreciation . Actually Marketing expenses are considered to be considered while dealing with the operating section analysis ie, net of income and expenses but here it's since they have mentioned specifically to be included in the beginning and marketing exp being an expense should be considered after taking the tax effect.

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VIMAL RAJ CHAKKINGAL
Student
India
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• #### 6.  RE: Capital Budgeting

Posted 05-26-2022 10:34 AM
Well I think the answer given is wrong. Initial outflow should be 4250,000. Tax saving on advt exp is not to be considered.

• #### 7.  RE: Capital Budgeting

Posted 05-27-2022 02:14 AM
Hi Shrihari! Expenses affect the company's taxable income so there is a need to adjust it by multiplying the cash flow by (1-tax rate).

Regards,
Jem

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Jemima Cerezo
Other
LUNA
Philippines
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• #### 8.  RE: Capital Budgeting

Posted 05-29-2022 10:55 PM
Initial cash outflow means outflow at year Yo,
these initial expenses may be capital expense or revenue expenses,

Note- we will consider tax saving on revenue expenses.

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Shubham Sharma
Gurugram
India
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• #### 9.  RE: Capital Budgeting

Posted 05-29-2022 11:16 PM
Yes you are right. Tax saving will be considered in this question. But not at the beginning of the year . In the answer to qno.2.6 ( Right way...)the tax saving has been considered at year beginning which I feel is incorrect .I  feel that, If the question specifically says that tax savings arise at the beginning of the year ,only then we shall consider tax savings at the beginning. Else we shall consider them at year end. Therefore initial outflows will be calculated without considering tax savings and will be 4250,000.

• #### 10.  RE: Capital Budgeting

Posted 05-31-2022 09:06 AM
hi, srihari
We pay tax at the end of the year and therefore tax savings should be calculated at year end. Therefore if we go by that logic we should not calculate tax savings in the initial outflow. But we dont follow this logic while solving questions. Why? Because In most of the questions the business is already existing and it has other sources of income and therefore tax saving on expenditure can be availed (set off) against other incomes of the business. If the question specifically states that the companuy does not have any other source of income then we will follow the first logic and calculate tax savings on year end only .
You can see qno.12 of part E of cma support package Pg.336(Agc company is considering...) where they have calculated tax savings on loss on disposal of old machine at the year beginning in the solution. So the answer of cma institute is correct. So we should assume that tax benefit of expenses can be availed as soon as those expenses occur and not at the year end while solving questions.

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Mohamed Khan
None
Haldwani UT
India
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• #### 11.  RE: Capital Budgeting Best Answer

Posted 06-03-2022 12:09 AM
Hi,everyone
I just want to correct myself. I found this question in wiley cmaexcel exam review 2015 and the answer they have to the initial outflow question is 4250,000.
so it seems answer given in the support package is wrong and we are not to consider tax savings on advt expenses in initial outflow.

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Mohamed Khan
None
Haldwani UT
India
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• #### 12.  RE: Capital Budgeting

Posted 06-10-2022 04:37 PM
Adding to this my second question:

2. Calculate the annual expected cash flow from the proposed new store. Show your calculations.

Ans as per material: 1,375,000 [ 1.2 M plus 175000]

But as per my calculation: for calculating annual cash flow:
we ll consider cash from operations (after-tax) : 1,200,000
Depreciation shield                                           :      61,250
Total                                                                  :  1,261,250
Is it correct?

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Shrihari Jayakumar
Other
Chennai TN
India
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• #### 13.  RE: Capital Budgeting

Posted 06-11-2022 07:33 AM
Hi sreehari.

If you are going through the question once again you will understand your mistake.
It's given that after tax operating income and NOT after tax operating cash flows.

If it's given after tax operating cash flows then you can add Dep. Tax shield  only if the given amount is Cash flow before tax ie, CFBT Inorder to arrive at CFAT ie, cash flow after tax.

Now in the question it's given  After tax OPERATING INCOME AND NOT CASH FLOW.
So for converting income to cash flow we need to ADD depreciation to the net income after tax.

Since land cannot be depreciated as per the accounting standards bcoz depreciation means allocation of the cost of fixed assets over its useful life and since land doesn't follow this concept and concept of matching principle land cannot be depreciated..

So here Dep amount is cost of the building / no of yrs.

Dep = 3500000/20 =175000.

So after tax cash flow =  1200000+175000= 1,375000.

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VIMAL RAJ CHAKKINGAL
Student