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Unformatted text preview: ing the halfyear convention and switching to straight-line when advantageous. Although
tables of depreciation percentages are not provided by law, the approximate percentages (rounded to the nearest whole percent) written off each year for the first
four property classes are shown in Table 3.2. Rather than using the percentages
in the table, the firm can either use straight-line depreciation over the asset’s
recovery period with the half-year convention or use the alternative depreciation
system. For purposes of this text, we will use the MACRS depreciation percentages, because they generally provide for the fastest write-off and therefore the
best cash flow effects for the profitable firm.
Because MACRS requires use of the half-year convention, assets are assumed
to be acquired in the middle of the year, and therefore only one-half of the first
year’s depreciation is recovered in the first year. As a result, the final half-year of
depreciation is recovered in the year immediately following the asset’s stated
recovery period. In Table 3.2, the depreciation percentages for an n-year class
asset are given for n 1 years. For example, a 5-year asset is depreciated over 6
recovery years. The application of the tax depreciation percentages given in Table
3.2 can be demonstrated by a simple example.
2. An exception occurs in the case of assets depreciated under the alternative depreciation system. For convenience,
in this text we ignore the depreciation of assets under this system.
3. For a review of these depreciation methods as well as other aspects of financial reporting, see any recently published financial accounting text. 100 PART 1 Introduction to Managerial Finance TABLE 3.2 Rounded Depreciation
Percentages by Recovery Year
Using MACRS for First Four
Percentage by recovery yeara Recovery year 3 years 5 years 7 years 10 years 1 33% 20% 14% 10% 2 45 32 25 18 3 15 19 18 14 4 7 12 12 12 5 12 9 9 6 5 9 8 7 9 7 8 4 6 9 6 10 6 11 4 Totals 100% 100% 100% 100% aThese percentages have been rounded to the nearest whole percent to simplify calculations while retaining realism. To calculate the actual depreciation for tax purposes, be sure to apply the actual unrounded percentages or
directly apply double-declining balance (200%) depreciation using the halfyear convention. EXAMPLE Baker Corporation acquired, for an installed cost of $40,000, a machine having a
recovery period of 5 years. Using the applicable percentages from Table 3.2,
Baker calculates the depreciation in each year as follows: Percentages
(from Table 3.2)
(3) Year Cost
(1) 1 $40,000 2 40,000 32 12,800 3 40,000 19 7,600 4 40,000 12 4,800 5 40,000 12 4,800 6 40,000 5 Totals 20% 100% $ 8,000 2,000
$40,000 Column 3 shows that the full cost of the asset is written off over 6 recovery years.
Because financial managers focus primarily on cash flows, only tax depreciation methods will be utilized throughout this textbook. CHAPTER 3 Cash Flow and Financial Planning 101 Developing the Statement of Cash Flows
The statement of cash flows, introduced in Chapter 2, summarizes the firm’s cash
flow over a given period of time. Before discussing the statement and its interpretation, we will review the cash flow through the firm and the classification of
inflows and outflows of cash.
Hint Remember that in
finance, cash is king. Income
statement profits are good, but
they don’t pay the bills, nor do
asset owners accept them in
place of cash. FIGURE 3.1 The Firm’s Cash Flows
Figure 3.1 illustrates the firm’s cash flows. Note that marketable securities are
considered the same as cash because of their highly liquid nature. Both cash and
marketable securities represent a reservoir of liquidity that is increased by cash Cash Flows
The firm’s cash flows
(1) Operating Flows
Wages Labor Raw
Materials (2) Investment Flows
Payment of Accruals Accounts
Purchases Purchase Fixed Assets Sale Depreciation Work in
Securities Operating (incl.
Interest Expense (3) Financing Flows
Borrowing Payment Taxes Repayment Refund Sales Cash Sales Sale of Stock
Repurchase of Stock
Payment of Cash Dividends Accounts
Receivable Collection of Credit Sales Debt
Long-Term) Equity 102 PART 1 Introduction to Managerial Finance operating flows
Cash flows directly related to
sale and production of the firm’s
products and services.
Cash flows associated with
purchase and sale of both fixed
assets and business interests.
Cash flows that result from debt
and equity financing transactions; includes incurrence and
repayment of debt, cash inflow
from the sale of stock, and cash
outflows to pay cash dividends or
repurchase stock. inflows and decreased by cash outflows. Also note that the firm’s cash flows can
be divided into (1) operating flows, (2) investment flows, and (3) financing flows.
The operating flows ar...
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