Question Tag: Exchange Rate

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  • 16 Marks

AT – May 2016 – L3 – Q5a – International taxation

Calculate tax credit relief available for a resident with income from the UK under a double taxation agreement.

Mrs. Olivia Quartey is a resident in Ghana and works as the Finance Director of Ghana Trustees Limited. She earned a gross salary of GH¢30,000.00 for the 2014 year of assessment. She contributed 5.5% of her salary to the social security fund. In 2014, the gross royalties that accrued to her was £4,000 from the United Kingdom from which tax of £800 had been deducted with the remainder of £3,200 being remitted to her in Ghana.

Granted that Ghana has a double taxation agreement with the United Kingdom, you are required to calculate the tax credit relief (if any) available to Mrs. Olivia Quartey for the year 2014.
[Exchange rate: GH¢4.50 = £1.] (16 marks)

Tax Rate Table

Income (GH¢) Rate (%)
First             1,584.00 Free
Next              792.00 5
Next              1,104.00 10
Next              28,200.00 17.5
Exceeding     31,680.00 25
  1. Effective Rate of Tax of the UK Income:

Tax Charged ×100=800×4.504,000×4.50×100=20%\text{Tax Charged } \times 100 = \frac{800 \times 4.50}{4,000 \times 4.50} \times 100 = 20\%

  1. Exchange Rate:
    800 × 4.50 = 3,600
    4,000 × 4.50 = 18,000

Effective Rate = 20%

  1. Computation of Ghana Tax Liability:
  • Salary in Ghana: GH¢30,000
  • Gross Income from UK: GH¢18,000
  • Total Income: GH¢48,000
  • Less SSF Contribution (5.5% of GH¢30,000): GH¢1,650
  • Chargeable Income: GH¢46,350

Income Tax Computation:

  • First GH¢1,584: Free
  • Next GH¢792 @ 5%: GH¢39.60
  • Next GH¢1,104 @ 10%: GH¢110.40
  • Next GH¢28,200 @ 17.5%: GH¢4,935.00
  • Remaining GH¢14,670 @ 25%: GH¢3,667.50

Total Ghana Tax Payable: GH¢8,752.50

  1. Average Tax Rate of Ghana:

Tax PayableChargeable Income×100=8,752.5046,350×100=18.88%\frac{\text{Tax Payable}}{\text{Chargeable Income}} \times 100 = \frac{8,752.50}{46,350} \times 100 = 18.88\%

Comparison of UK and Ghana effective rates shows Ghana’s rate is lower.
Thus, the UK income will be taxed at Ghana’s average rate:

  • Tax on Total Income: GH¢8,752.50
  • Less Foreign Tax Credit (18.88% of GH¢18,000): GH¢3,398.40
  • Final Tax Liability: GH¢5,354.10
  • 25 Marks

FM – MAY 2017 – L2 – Q2 – Foreign exchange risk and currency risk management | Introduction to Investment Appraisal

Discuss the advantages and disadvantages of the payback method, calculate the NPV for DÉCOR Ltd's investment, and analyze currency risk in an international transaction.

a) Payback method refers to the period of time it takes for the cash flows to cover the initial cost of investment or recoup the initial cost of investment. The period is usually calculated in years.

Required:
Identify TWO advantages and TWO disadvantages of using the payback method in investment appraisal.
(4 marks)

b) DÉCOR Ltd is analyzing the purchase of a new machine to produce product Z. The machine is expected to cost GH¢2,000,000. Production and sales of product Z are forecast as follows:

Year 1 2 3 4
Production & Sales (units/year) 70,000 106,000 150,000 72,000

The current selling price is GH¢30 per unit and is expected to increase by 5% a year. The current variable cost is GH¢18 per unit and is expected to increase by 6% per year. Fixed costs will remain the same, but an increase in working capital is required. Analysis of historical data of the levels of working capital of product Z indicates that, at the start of each year, investment in working capital will need to be 10% of sales revenue of that year.

The company pays tax at 25% per year in the year in which taxable profit occurs. The tax liability is reduced by the capital allowance on the machinery, and DÉCOR Ltd can claim on a straight-line basis over the four-year life of the proposed investment (capital allowance rate of 25% per annum). The new machine will have zero scrap value at the end of the four years. The cost of capital is 15% per year.

Required:
Calculate the Net Present Value (NPV) of the proposed investment and advise whether the proposed investment should be undertaken.
(11 marks)

c) An American company sells goods to a Ghanaian buyer for US$280,000 when the exchange rate is $1 = GH¢4.20. The Ghanaian buyer is allowed three months’ credit, and when the American company eventually receives the US dollars three months later and exchanges them for dollars, the exchange rate has moved to $1 = GH¢4.60.

Required:
i) What was the foreign exchange loss to the Ghanaian buyer?
(3 marks)

ii) Explain currency risk in relation to the above.
(2 marks)

iii) Explain transaction risk in relation to the above.
(2 marks)

iv) What will be the effect of the above on the company’s trading profits?
(3 marks)

a) Advantages and Disadvantages of Payback Method

Advantages:

  1. Simplicity: The payback method is easy to calculate and understand, making it accessible to managers without extensive financial expertise.
  2. Liquidity Focus: It provides a quick estimate of the liquidity risk by showing how quickly an investment can recover its initial cost.

Disadvantages:

  1. Ignores Time Value of Money: The method does not account for the time value of money, meaning future cash flows are treated as equally valuable as immediate ones.
  2. Ignores Cash Flows After Payback: It only considers the period until the initial investment is recovered and disregards any cash flows that occur after the payback period.

b) NPV Calculation for DÉCOR Ltd’s Proposed Investment

Revenue Calculations:

Year 1 2 3 4
Units Sold 70,000 106,000 150,000 72,000
Selling Price (GH¢) 30 31.5 33.08 34.73
Sales Revenue (GH¢) 2,100,000 3,339,000 4,962,000 2,500,560

Variable Costs Calculations:

Year 1 2 3 4
Units Sold 70,000 106,000 150,000 72,000
Variable Cost (GH¢) 18 19.08 20.22 21.44
Total Variable Costs (GH¢) 1,260,000 2,022,480 3,033,000 1,543,680

Net Cash Flow Calculations:

Year 0 1 2 3 4
Sales Revenue (GH¢) – 2,100,000 3,339,000 4,962,000 2,500,560
Variable Costs (GH¢) – (1,260,000) (2,022,480) (3,033,000) (1,543,680)
Fixed Costs (GH¢) – – – – –
Contribution (GH¢) – 840,000 1,316,520 1,929,000 956,880
Capital Allowance (GH¢) (2,000,000) 500,000 500,000 500,000 500,000
Taxable Profit (GH¢) – 340,000 816,520 1,429,000 456,880
Tax @ 25% (GH¢) – (85,000) (204,130) (357,250) (114,220)
Net Profit After Tax (GH¢) – 255,000 612,390 1,071,750 342,660
Add: Capital Allowance (GH¢) – 500,000 500,000 500,000 500,000
Net Cash Flows (GH¢) (2,000,000) 755,000 1,112,390 1,571,750 842,660
Working Capital Requirement (GH¢) (210,000) (123,900) (162,300) 246,144 250,056
Net Cash Flow After WC (GH¢) (2,210,000) 631,100 950,090 1,817,894 1,092,716
Discount Factor @ 15% 1.000 0.8696 0.7561 0.6575 0.5718
Present Value (GH¢) (2,210,000) 548,805 718,363 1,195,265 624,815

Net Present Value (NPV): GH¢877,248
Decision: The project should be undertaken since the NPV is positive, indicating an addition to shareholder value.

c) Currency Risk Analysis

i) Foreign Exchange Loss to the Ghanaian Buyer: The original expectation was to pay:

US$280,000×GH¢4.2=GH¢1,176,000

However, the payment after the exchange rate change was:

US$280,000×GH¢4.6=GH¢1,288,000

Foreign Exchange Loss = GH¢112,000

ii) Currency Risk Explanation: Currency risk arises from exposure to the consequences of a rise or fall in an exchange rate. Here, the Ghanaian buyer was exposed to the risk of a fall in the value of the cedi, leading to a higher payment in cedi terms.

iii) Transaction Risk Explanation: Transaction risk occurs when a financial transaction is settled at a future date, exposing the company to potential exchange rate fluctuations. Here, the risk lasted from when the goods were sold on credit until the time of payment.

iv) Effect on Company’s Trading Profits: Trading profits can be significantly affected by currency movements. In this case, the foreign exchange loss of GH¢112,000 reduces the company’s profit, highlighting the impact of exchange rate volatility on financial performance.

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