Although tables of depreciation percentages are not

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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 Property Classes 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) (2) Depreciation [(1) (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 Accrued Wages Labor Raw Materials (2) Investment Flows Payment of Accruals Accounts Payable Payment of Credit Purchases Purchase Fixed Assets Sale Depreciation Work in Process Overhead Expenses Business Interests Finished Goods Purchase Sale Cash and Marketable Securities Operating (incl. Depreciation) and 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 (Short-Term and 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. investment flows Cash flows associated with purchase and sale of both fixed assets and business interests. financing flows 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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This document was uploaded on 01/19/2014.

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