[Anonymous]

I’ve looked at this question 4-5 times and it is still not clicking with me. Has anyone been able to tackle it with a more simple solution? Provided answer doesn’t seem to make much sense for me. Thanks for your help.

Whatney Co. is considering the acquisition of a new, more efficient press. The cost of the press is $360,000, and the press has an estimated 6-year life with zero salvage value. Whatney uses straight-line depreciation for both financial reporting and income tax reporting purposes and has a 40% corporate income tax rate. In evaluating equipment acquisitions of this type, Whatney uses a goal of a 4-year payback period. To meet Whatney’s desired payback period, the press must produce a minimum annual before-tax, operating cash savings of:

A.

$90,000.

B.

$110,000.

C.

$114,000.

D.

$150,000.

answer:

Payback period is the number years required to repay the initial investment in a capital project. A $360,000 capital investment would need an after-tax cash flow of $90,000 to meet the goal of a 4-year payback. The key to solving this problem involves remembering to consider the cash savings resulting from decreased taxes due to the depreciation expense. Note that the problem asks for the operating cash savings.

In this problem, operating cash savings would be total cash savings less nonoperating cash savings (e.g., cash savings from lower taxes). Annual depreciation on a $360,000 asset with an estimated 6-year life with zero salvage value using straight-line depreciation is $60,000. The tax savings generated by this depreciation is $60,000 times 40%, or $24,000. Now calculate after-tax operating cash savings: $90,000 – $24,000 = $66,000. However, the problem asks for before-tax operating cash savings, calculated as follows:

$66,000 ÷ (1 – Tax rate of 0.40) = $66,000 ÷ 0.60 = $110,000