CMA Study Group

Olson Industries needs to add a small plant to accommodate a special contract to supply building materials over a 5-year period. The required initial cash outlays at Time 0 are as follows:  Land          $  500,000  New building   2,000,000  Equipment      3,000,000Olson uses straight-line depreciation for tax purposes and will depreciate the building over 10 years and the equipment over 5 years. Olson's effective tax rate is 40%.Revenues from the special contract are estimated at $1,200,000 annually and cash expenses are estimated at $300,000 annually. At the end of the fifth year, the assumed sales values of the land and building are $800,000 and $500,000, respectively. It is further assumed that the equipment will be removed at a cost of $50,000 and sold for $300,000.As Olson utilizes the net present value (NPV) method to analyze investments, the net cash flow for Period 3 would be:

Select an answer:

A.$60,000.

B.$820,000.

C.$880,000.

D.$940,000.

 

You are correct, the answer is B.Period 3 net cash flow:Revenues                               $1,200,000Less:  Cash expenses             $300,000  Income taxes (see below)    80,000                            --------  Total expenses                          380,000                                       ----------Net cash inflow                        $  820,000                                       ==========Taxable income:Revenues            $1,200,000Less:  Cash expenses       (300,000)  Depreciation        (700,000)                    -----------Taxable income      $  200,000x Tax rate          x      .40                    -----------Income tax expense  $   80,000

 

As you see above the correct answer according to exmamatrix software is 820,000. while I am thinkin that the correct answer suppose to equal 860,000

Please try to slove this example and provide me with your feedback

 

Rashid,

I tried to solve the problem and I got the same result 860,000. Operating Cash flow (1,200,000-300,000=900,000*60%)=540,000 Plus Depreciation Tax Shield (200,000+600,000=800,000*40%)=320,000. Net Cash Flow 860,000.

I believe there is problem particularly in the depreciation calculation.

Regards,

Walter

 

the correct answer is $860,000 for the net cash flows in year3 based on the data you gave us

Year3 Data:

Operating A.T. NeT Cash Flows:

1)Depreciation Tax Shield

Total Depreciation = $MM2 /10 + $MM3/5=$800,000 , thus Depreciation tax shield (tax saving) = 800,000 x %40 = $320,000

2) annual Net cash flows

Inflows - outflows = $900,000 , A.T. net cash flows = 900,000 x %60 (1-T) = $540,000

Finally net cash flow in year3 will equal $M320 + $M540 = $M860

the problem exactly in the total depreciation, i think the data of equipment or building have an error either in the Depreciable life of equipment may be 6 or in the cost of building may be $1000,000 because the data should give us total depreciation of $700,000

 

Yes the Depreciation has been caculated in the above problem was 700000 while it suppose to be 800,000 this what made the deffirent. I think I should return my money back

Is my calculating way wrong?

Because

2000 000/10 =200 000 depreciation of building yearly

3000 000-(300 000-50000)=2750 000 the net value of Equipment

2750 000/5 =550000 depreciation value of Equipment

550 000 +200 000=850 000 taxable value

850 000*40 % =340 000 tax shield

340 000+540 000=880 000

Dear Malik The depreciation is calculated from the actual value of the equipment which is 3 milion so dep. will be 600,000 (3000000/5) the tax saving is 240,000 (600000x40%)+ the tax saving from building dep. 80,000 (200000x40%)so tax sheild = 240,000+80,000= 320,000 320,000+540,000=860,000

The cash flow from operations net of tax is 540,000 (1,200,000 - 300,000 = 900,000 *.4 = 540,000)

The tax benefit from the depreciation on the building is 2,000,000,- 500,000 (1,500,000) / 10 (150,000) * .4 which is 60,000

The tax benefit from the equipment is 3,000,000 - 300,000 + 50,000 (the 50,000 cost of removing the equipment is part of the expense 2,750,000) / 5 (550,000) * .4 which equals 220,000

540,000 + 60,000 + 220,000 = 820,000

  Regards,  Scott

Though the est life of the bldg and eqpt is 10 yrs and 5 years respectively, salvage value is assumed during their life. In straigh-line method, depreciation exp is calculated based on depreciable cost meaning, cost less salvage value. Unlike in accelerated method of depreciation or MACRS, which is sometimes given in the problem, depreciation expense is calculated based on cost only.

Hence, the suggestion of Scott seems correct. And if we believe that our calculation is surely correct and the answer is not there, the last thing we can do is we have to work around with the question like the question above.

Regards,

Walter

 

 

 

Dear all

- when we calculate depreciation based on straight line metod : ther are 2 main factors

1- depreciable cost = acquring cost (purchase+any related services' cost until the asset is ready for use) - salvage value

2- depreciable life (accounting period over which the acquiring cost will be systematically allocated 

we get depreciation (systematic allocation) through dividing 1- by 2

but in the above problem (question) , i believe that assumed sales value  differ than salvage value

the first should be considered to get the cash inflow at the life end of the project

and the second should be considered only to derive depreciation expense 

the assumed  sales value may differ than salvage value , this is my think

but anyway, if we considered assumed sales value to be synonymum to salvage value then

the method apllied by Scott Hansen is exactly right

NB. my above concept is derived from gleim Book fourteenth edition page no. 409 question no.11

 

 

 

  I think you've alluded to what is a better explaination than what I wrote (I thought about this after I posted the reply). The cost of removal reduces the salvage value and the difference betweeen the acquisition cost and the adjusted salvage value is the straight line depreciable base. The estimated value to be realized when the equipment is sold for salvage value is reduced by the cost to remove it.

  Regards,  Scott

Thanks Scott and all

thus we will add to our knowledge the following information

1- salvage value (expected proceeds of asset's disposal) should be adjusted for any cost related to the disposal of an asset at its end life

2- salvage value should be deducted from the asset's acquiring cost to get the depreciable base when straight line depreciation method is applied

3- asset carrying cost at its life end will be its salvage value that should be compared to net proceeds of disposal to get book profit or loss on disposal  but for cash flows analysis we should compare  taxable base to the disposal price for deriving the tax expense and then after tax cash flow from disposal = net disposal price (disposal price - any removal or commision cost) - taxable basis (acquiring cost - cummulative depreciation allowed by tax autority) X (1-tax rate)  

best wishes to all

Hesham A.Khalek

 

well put

 

 

 Hi,

 

  The cash flow for the third year is impacted by the tax shield from the depreciation expense recorded for that year. The depreciation (for straight line) is the cost minus the salvage value divided by the estimated useful life. In this case the cost is 3,000,000 and the salvage value is 300,000 minus the cost of removal of 50,000 or 250,000. So the deprecable base is 3,000,000 - 250,000 = 2,750,000. The estimated useful life is 5 years so the depreciation expense in the third year is 550,000. The tax shield resulting from the non-cash depreciation expense is 220,000 (550,000 * .4). The 220,000 represents the cash flow benefit of the project for the equipment.

  Does that help clarify?

 

Hi Scote My question is why assume that the equipment/ building sale price is a salvage value I mean why not this amount to be a (gain) over the book value which is suppose to be zero in the fifth year for equipment and and 1000000 (2000000/10 X5) for building. so for example if the question was about the net cash flow for the 5th year the answer will be cash flow, revenue= 540,000 cash flow fro dep.tax saving (3000000/5x0.4)+(2000000/10x0.4)= 320,000 cash flow from selling equipment (300000-50000*.6)gain = 150,000 cash flow from selling building (500000-1000000x0.4) loss = 200,000 cash flow from selling land (800000-500000x0.6)gain= 180,000 Total 1,390,000 I agree with you Scote but is this a salvage value to be deducted from asset initial value and in the example above I tryed to reflect my point of view.

Hi Rashid,

   The book value would not be zero in the fifth year for the equipment because the straight line method of depreciation takes the salvage value into account. The cash flow from the sale of the equipment has no impact on the cash flow for the third year since the sale (cash flow) does not happen until the fifth year. Once the depreciation for the year is calcualted the cash flow impact is the tax savings (in this case 40%). The eventual sale has no cash flow impact until that sale is scheduled to take place (or really until the sale actually takes place). I think you are determining the net cash flow effect from the sale and allocating it to the years prior to the sale.

 

  Regards,  Scott