As you checked the Answer Key to Question 6 in the Mastery Check from this lesson you may have noted that each year's net cash flows are calculated by adding depreciation back to net earnings:
Question 6 Jayhawk Company has a proposed contract with the Comprehensive Systems of Kansas. The initial investment in land and equipment will be $120,000. Of this amount, $70,000 is subject to fiveyear MACRS depreciation. The balance is in nondepreciable property. The contract covers six years. At the end of six years, the nondepreciable assets will be sold for $50,000. The depreciated assets will have zero resale value.
The contract will require an investment of $55,000 in working capital at the beginning of the first year, and, of this amount, $25,000 will be returned to the Jayhawk Technology Company after six years.
The investment will produce $50,000 in income before depreciation and taxes for each of the six years. The corporation is in a 40 percent tax bracket and has a 10 percent cost of capital.
Using a piece of paper or a computer spread sheet, determine whether or not the investment should be undertaken. Use the net present value method.
Answer
Problem 6


Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

EBIDT


50,000

50,000

50,000

50,000

50,000

50,000

Depreciation


14,000

22,400

13,440

8,050

8,050

4,060

Earnings before taxes


36,000

27,600

36,560

41,950

41,950

45,940

Taxes


14,400

11,040

14,624

16,780

16,780

18,376

Earnings after taxes


21,600

16,560

21,936

25,170

25,170

27,564

Depreciation


14,000

22,400

13,440

8,050

8,050

4,060

Cash flow


35,600

38,960

35,376

33,220

33,220

31,624

Investment

120,000






50,000

Net work capital

55,000






25,000


175,000






106,624

NPV = 19,564 @ 10% cost of capital (The answer is $19,643 with a financial calculator.)

On the other hand, the problem in Part 1 of this assignment specifies a series of steps that leads you through the same approach as that used in the answer key for Question 8 in the Mastery Check of this lesson:
Question 8 The Acme Corporation is considering the purchase of an additional lathe to handle periodic overload conditions in the shop. By reducing overtime premiums, purchase of this lathe will result in cash savings of $20,000 per year before taxes. The new lathe would cost $50,000 and would be depreciated using 5 year MACRS. However, it is anticipated that it would be sold at the end of 5 years for an estimated $15,000.
Using a piece of paper or a computer spreadsheet, calculate the aftertax cash flows for this investment proposal using the method described in the discussion material for this lesson. (That is, calculate the aftertax cash flows as if there were no noncash expenses.) Then adjust these aftertax cash flows for the tax credits resulting from the noncash tax shields. Calculate the net present value of this investment proposal using a 15% discount rate. Acme's marginal tax rate is 40%.
Answer
Problem 8


Year 0

Year 1

Year 2

Year3

Year 4

Year5

EBIDT


20,000

20,000

20,000

20,000

20,000

(1) After tax @ 40% tax rate


12,000

12,000

12,000

12,000

12,000

Depreciation


10,000

16,000

9,600

5,750

5,750

(2) Depreciation tax credit


4,000

6,400

3,840

2,300

2,300

Yearly cash flow (1) + (2)


16,000

18,400

15,840

14,300

14,300

Investment/salvage

50,000





10,160

Total cash flow

50,000

16,000

18,400

15,840

14,300

24,460

NPV = $8,589.34 @ 15% cost of capital. (Answer is $8,578.16 with a financial calculator)

Depreciation and Book Value







Year

0

1

2

3

4

5

Depreciation percent


0.200

0.320

0.192

0.115

0.115

Depreciation


10000

16000

9600

5750

5750

Remaining book value


40000

24000

14400

8650

2900








Sale price






15000

Book value






2900

Taxable profit on sale






12100

Tax on profit on sale






4840

Net proceeds from sale






10160

Rework and submit Question 6 using the same approach to calculate each year's aftertax cash flows as is used to solve Question 8.
That is, calculate the aftertax cash flows as if there were no noncash expenses. Then, adjust these aftertax cash flows for the tax credits resulting from the noncash tax shields. (This is the method the problem in Part 1 leads you through as you follow the specified steps a through o for solving that problem).
Carefully examine the solution to Problem 6, but solve it using this alternative method. Be sure to check your answer. If you get a different answer than the Answer Key gives for Problem 6, you have made an error.