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 five-year MACRS depreciation. The balance is in non-depreciable property. The contract covers six years. At the end of six years, the non-depreciable 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
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Problem 6
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Year 0
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Year 1
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Year 2
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Year 3
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Year 4
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Year 5
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Year 6
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EBIDT
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50,000
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50,000
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50,000
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50,000
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50,000
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50,000
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Depreciation
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14,000
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22,400
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13,440
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8,050
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8,050
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4,060
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Earnings before taxes
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36,000
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27,600
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36,560
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41,950
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41,950
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45,940
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Taxes
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14,400
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11,040
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14,624
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16,780
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16,780
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18,376
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Earnings after taxes
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21,600
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16,560
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21,936
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25,170
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25,170
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27,564
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Depreciation
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14,000
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22,400
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13,440
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8,050
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8,050
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4,060
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Cash flow
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35,600
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38,960
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35,376
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33,220
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33,220
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31,624
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Investment
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-120,000
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50,000
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Net work capital
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-55,000
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25,000
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-175,000
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106,624
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NPV = 19,564 @ 10% cost of capital (The answer is $19,643 with a financial calculator.)
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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 after-tax cash flows for this investment proposal using the method described in the discussion material for this lesson. (That is, calculate the after-tax cash flows as if there were no non-cash expenses.) Then adjust these after-tax cash flows for the tax credits resulting from the non-cash tax shields. Calculate the net present value of this investment proposal using a 15% discount rate. Acme's marginal tax rate is 40%.
Answer
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Problem 8
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Year 0
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Year 1
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Year 2
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Year3
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Year 4
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Year5
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EBIDT
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20,000
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20,000
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20,000
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20,000
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20,000
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(1) After tax @ 40% tax rate
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12,000
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12,000
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12,000
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12,000
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12,000
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Depreciation
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10,000
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16,000
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9,600
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5,750
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5,750
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(2) Depreciation tax credit
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4,000
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6,400
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3,840
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2,300
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2,300
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Yearly cash flow (1) + (2)
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16,000
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18,400
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15,840
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14,300
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14,300
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Investment/salvage
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-50,000
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10,160
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Total cash flow
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-50,000
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16,000
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18,400
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15,840
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14,300
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24,460
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NPV = $8,589.34 @ 15% cost of capital. (Answer is $8,578.16 with a financial calculator)
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Depreciation and Book Value
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Year
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0
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1
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2
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3
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4
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5
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Depreciation percent
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0.200
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0.320
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0.192
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0.115
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0.115
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Depreciation
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10000
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16000
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9600
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5750
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5750
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Remaining book value
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40000
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24000
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14400
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8650
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2900
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Sale price
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15000
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Book value
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2900
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Taxable profit on sale
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12100
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Tax on profit on sale
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4840
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Net proceeds from sale
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10160
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Rework and submit Question 6 using the same approach to calculate each year's after-tax cash flows as is used to solve Question 8.
That is, calculate the after-tax cash flows as if there were no non-cash expenses. Then, adjust these after-tax cash flows for the tax credits resulting from the non-cash 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.