This question required candidates to calculate the net present value (NPV) of a planned purchase of machinery using a nominal (money terms) approach. Most candidates did well on this part of question 1.

Most candidates adopted a pro-forma approach to their calculation, with operating cash flows at the start and other cash flows (tax and capital elements) later. The advantage of adopting this approach is that errors in the tax treatment of cash flows can be avoided. For example, scrap value is not subject to corporation tax (profit tax) because it is a capital cash flow, and so it should not be included with the operating cash flows.

Working capital investment, both initial and incremental, is also a capital cash flow and so does not give rise to corporation tax benefits, i.e. it is not a tax-deductible item. Both of these cash flows were the subject of errors made by some candidates.

Most candidates correctly applied specific inflation to operating cash flows (sales income, variable cost and fixed cost). The question stated that buying the new machine would increase production capacity by 9,000 units per year; however some candidates took this to mean 9,000 units in year 1, 18,000 units in year 2 and so on. They were not penalised for this error, however.

Tax liability was stated in the question to be paid one year in arrears, but some candidates ignored this information and made the liability payable in the year in which it arose, losing a mark as a consequence. Capital allowances (tax-allowable depreciation) was available to the investing company on a 25% reducing balance basis and many candidates calculated the capital allowances and associated benefits correctly.

Most candidates calculated the tax benefits in workings and then made a one-line entry for these tax benefits in their NPV calculation. Some candidates subtracted the capital allowances from net cash flow (sales income minus variable cost and fixed cost) to give taxable profit, and then added back the capital allowances after calculating the tax liability on the taxable profit.

The net effect is the same whichever method is used. However, some candidates lost a mark by forgetting to add back capital allowances in the second method.

The item that gave most difficulty with the capital allowance calculations was the balancing allowance. The point to remember is that the sum of the capital allowances and the balancing allowance must equal the cost of machinery minus the scrap value. Alternatively, the cost of machinery minus the scrap value, multiplied by the corporation tax rate, must equal the total tax benefit.

Some candidates had difficulty calculating the incremental working capital investment, which was needed because the working capital was subject to the general rate of inflation. The new machine was planned to be replaced at the end of four years and so production to meet the increased demand would continue. Working capital should not therefore have been recovered at the end of the four-year life of the new machine, although students who did recover the working capital were not penalised.

A small number of candidates, without explanation, used less than four years to evaluate the planned purchase of the new machine and lost marks as a consequence.

The majority of candidates used the nominal discount rate provided to discount the nominal cash flows they calculated. The question called for a comment on the financial acceptability of the planned purchase and most answers correctly referred to its positive NPV as the basis for this acceptability.

A small number of candidates lost marks by carelessly not referring to NPV. For example, writing “so accept” after the calculated NPV does not explain the reason for recommending acceptance.