Depreciation tax shield Depreciation exp x Marginal Tax Rate Computing

# Depreciation tax shield depreciation exp x marginal

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Depreciation tax shield = Depreciation exp. x Marginal Tax Rate Computing Depreciation Straight-line depreciation MACRS After-Tax Salvage If the salvage value is different from the book value of the asset, then there is a tax effect. Book Value = Initial Cost Acc. Dpn. After-Tax Salvage = Salvage T(Salvage Book Value) o E.g. If Salvage (\$10) < Book Value (\$15) and Tax = 30%, After-Tax Salvage = \$10 0.3(10 15) = \$11.50 Since Salvage < Book Value = Recovered less than what you expected What was taxed? \$10 x 0.3 = \$3 and \$5 x 0.3 = \$1.50 => \$4.50 o E.g. If Salvage (\$10) > Book Value (\$5) and Tax = 30%, After-Tax Salvage = \$10 0.3(10 5) = \$8.50 Since Salvage > Book Value = Recovered more than what you expected
16 Special Cases of Evaluating Discounted Cash Flow Analysis First Case: Evaluating Cost-Cutting Proposals Company is considering automating some parts of an existing production process. Information Provided Costs: \$80,000 To buy and install Savings: \$22,000 per year (Before taxes) Useful life of Equipment: 5-year life (Straight-line depreciation, zero salvage value) Other Information: Can be sold for \$20,000 in 5 years, Tax Rate = 34% and Discount Rate is 10% Workings Year 0 1 2 3 4 5 Capital Spending \$(80,000) \$13,200 Op. Cash Flow \$19,960 \$19,960 \$19,960 \$19,960 19,960 Total Project Cash Flow \$(80,000) \$19,960 \$19,960 \$19,960 \$19,960 \$33,160 Method 1: Op. Cash Flow (Year 1 4) = \$(22,000 x 0.66) + 16,000 x 0.34 = \$19,960 Method 2: Op. Cash Flow (Year 1 4) = \$(22,000 16,000) x 0.64 + 16,000 = \$19,960 After-Tax Salvage = Salvage T (Salvage Book Value) = \$20,000 0.34 (20,000 0) = \$13,200 NPV = \$(80,000) + 19,960 [ (1 1/1.1 4 ) / 0.1 ] + 33,160 / (1.1 5 ) = \$3,860
17 Second Case: Setting the Bid Price A local distributor has requested bids for 5 specially modified trucks each year for the next four years, for a total of 20 trucks in all. Information Provided Truck Platforms = \$10,000 each Facilities = \$24,000/year Labour and Material Costs = \$4,000 per truck Other information: Need to invest \$60,000 (new equipment, 4-year straight-line dpn, 5,000 salvage value), \$40,000 (Raw Materials and other working capital), Tax Rate = 39%, Discount Rate = 20%) Workings Year 0 1 2 3 4 Capital Spending \$(60,000) \$3,050 Op. Cash Flow - + OCF + OCF + OCF + OCF Changes in NWC (40,000) 40,000 Total Project Cash Flow \$(100,000) + OCF + OCF + OCF + OCF + \$43,050 Total Cost Per Year = \$24,000 + 5 (10,000 + 4,000) = \$94,000 Changes in NWC (Year 0) = Ending NWC Beginning NWC = 40,000 0 NOTE: ALWAYS REMEMBER TO ADD BACK NWC) After-tax Salvage = 5,000 0.39 (5,000 0) = \$3,050 NPV = 0 = \$(100,000) + OCF x [ (1 1/1.2 4 ) / 0.2 ] + 43,050 / (1.2 4 ) = -79,239 + OCF x 2.58873 OCF = 79,239 / 2.58873 = \$30,609 OCF = NI + Dpn = 30,609 NI = \$30,609 15,000 = \$15,609 NI = (Sales Cost Dpn) x (1 T) = (Sales 94,000 15,000) x (0.61) = 15,609 Sales = \$134,589
18 Third Case: Evaluating Equipment Options with Different Lives Equivalent Annual Cost (EAC) The present value of a project’s costs calculated on an annual basis. Machine A: Cost = \$100 to buy, \$10/year to operate Must be replaced every 2 years. Machine B: Cost = \$140 to buy, \$8/year to operate Must be replaced every 3 years Workings PV, Machine A = - \$100 10 [ (1 1/1.1 2 ) / 0.1 ] = - \$117.36 PV, Machine B = - \$140 8 [ (1 1/1.1 3 ) / 0.1 ] = - \$159.89 Two year Annuity Factor, 10% = (1 1/1.1 2 ) / 0.1 = 1.7355 Three year Annuity Factor, 10% = 2/4879 For Machine A, PV of Costs = -\$117.36 = EAC x 1.7355 EAC = -67.72 For Machine B, PV of Costs = -\$159.89 = EAC x 2.4879 EAC = -64.29 We should purchase Machine B.
19 Fourth Case: Replacement Problem Original Machine: New Machine Initial Cost = 100,000 Annual Depreciation = 9,000 Purchased 5 years ago Book Value = 55,000 Salvage Today = 65,000 Salvage in 5 years = 10,000 Initial Cost = 150,000 5-year life Salvage in 5 years = 0

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