Tax and cash profit

Tax and cash profit

Tax payable on profit is deducted from the cash profit, because tax will be paid and this will reduce cash inflows, similarly tax saved on depreciation would be added to cash profit, because such this is tax saving.

Tax and cash profit Example

ABC Co cash profit is 50,000. Tax rate is 30%, while depreciation charged during the year was 10,000. Calculate the net cash flow.

Solution

Cash profit = 50,000

Less tax Expenses i.e. 30% of 50,000 (Cash profit) = (15,000)

Add tax saving i.e. 30% of 10,000 (Depreciation) = 3,000

Net Cash Flow = 38,000

It is important to remember that income increase tax expense, while expense reduces tax expense.

Balancing Depreciation

 Balancing Depreciation

Balancing depreciation concept is widely used at the end of project. When the project is ended then assets is to be fully depreciated. This concept has been explained below with example.

Balancing Depreciation Example

ABC & Co purchased Machinery for a project costing 100,000. The project life was three year and asset to be depreciated @ 30% reducing balance method. At the end of year 3, the residual value of machinery was 50,000. Calculate the depreciation for all three years.

Solution

Year 1 Depreciation = 100,000 x 30% = 30,000

Year 2 Depreciation = (100,000-30,000) x 30% = 21,000

Year 3 WDV = 100,000- 30,000-21,000 = 49,000

Year 3 Depreciation = 50,000 (Residual Value) - 49,000 (WDV at beginning) = 1000 (Depreciation)

As the project has ended so therefore the asset is to be fully depreciated in year 3, and this can be done by following formula, it is to be noted that depreciation rate is no more relevant is year 4 (at end of project).

Example of Balancing Depreciation

Example of Balancing Depreciation

Machinery written down value at the beginning of year was 30,000 and residual value at the end of year 4 is 40,000. Project life was four year?

Solution

As the project has ended so therefore the asset is to be fully depreciated in year 4, and this can be done by following formula, it is to be noted that depreciation rate is no more relevant is year 4 (at end of project).

Depreciation = Residual value end of year 4 – WDV at beginning of year 4

= 40,000-30,000

= 10,000 (balancing depreciation for year 4 or at end of project)

Future Annuity Example

Future Annuity Example

Present value of Future annuity may be calculated by the following formula

C x (Annuity Factor) x Discount Factor

Future Annuity Example

Mr. Sheraz Khan contacted an insurance company for annuity. He was offered an annuity amount of $ 25,000 for 3 years. Discount rate for annuity is 8%.  Calculate the present value of the annuity, where annuity start in 4 years

Solution

In first place annuity present value is calculated at year 4, and then it is further discounted at zero year. it means the future annuity calculation, we need to perform discounting twice.

1.    Calculate the annuity at year 4

= 1-(1.08)^-3

        .08

=2.577

= $ 25,000 x 2.577

=64,427

2.    Discount the present value at year zero

$ 64,427 x (1+.08)^-4

=$64,427 x .7350

=47,353

Tip of future annuity

Two present value are calculated

1.    Present value is calculated at future year by annuity factor (Single Value)

2.    Present value is calculated by discounting the value calculates by annuity factor.

Dividend to Earning Ratio and Dividend Growth

Dividend to Earning Ratio and Dividend Growth

High dividend to earnings ratio negatively impacts the dividend future growth. This is because funds are not reinvested for earn profit in future, rather it is paid. This concept can be explained by following example

Dividend to earnings Ratio = (Dividend)

                             (Earning)

Divided to earnings Ratio example

A company has paid divided 5 million & 10 million during the year 2001 & 2002 respectively. The earning of the company was 20 million each year. the rate of investment is 15%.

Solution

1.    10 million Dividend payment

= Dividend/earning

= 5million/20 million

= 25%

Dividend Growth = 75% x 15%

=11.25% (Dividend Growth)

2.    5 million dividend payment

= Dividend/earning

= 10 million/20 million

= 50%

Dividend Growth = 50% x 15%

=7.5% (Dividend Growth)

Above example shows that with high dividend to earnings ratio, you will achieve low growth rate, while in case of low dividend to earnings ratio, you will achieve high dividend growth.

Dividend to Earning Ratio

Dividend to Earning Ratio

Dividend to earning ration can be express by simple formula. It is important remember that high ratio reflect that high amount is paid to the shareholder, where low ratio reflect the low payout to the equity holder.

Dividend to earnings Ratio = (Dividend)

                             (Earning)

Divided to earnings Ratio example

A company has paid divided 10 million & 15 million during the year 2001 & 2002 respectively. The earning of the company was 25 million each year.

Solution

1.    10 million Dividend payment

= Dividend/earning

= million/25 million

= 40%

2.    15 million dividend payment

= Dividend/earning

= million/25 million

= 60%

Above answer clearly shows that high dividend to earnings ratio means that you are distributing most of profit to equity holders.

Dividend Growth and Rate of Investment

 Dividend Growth and Rate of Investment

Dividend Growth and rate of investment relationship was explained by the Gordon by a formula i.e. Growth = Retention x rate of investment. It suggests that with higher rate of investment, we can expect higher growth in future. This relationship has been explained with below example,

 Dividend Growth and Rate of investment Example

F & Co rate of investment for 2001 & 2002 is 5% and 8% respectively. F & Co has consistent policy to retain 50% of its earning. Calculate the divided for both years?

Solution

Gordon Growth of Dividend = Retained Earning x Return, this formula can be expressed

G=Br

Where,

G= Dividend Growth Rate

B= Retained earning

r= Rate of return on equity

1.    Rate of investment 5%

= 50% x 5%

=2.5%

1.    Rate of investment 8%

= 50% x 8%

=4%

The above results clearly that rate of investment the growth rate increases.