[Felix The Cat]

“McQueen, Inc., is considering the purchase of a new machine that will cost $150,000. The machine has an estimated useful life of three years. Assume for simplicity that the equipment will be fully depreciated 30, 40, and 30% in each of the three years, respectively (Not CCA). The new machine will have a $10,000 resale value at the end of its estimated useful life. The machine is expected to save the company $85,000 per year in operating expenses. McLean uses a 40% estimated income tax rate and a 16% hurdle rate to evaluate capital projects.

Discount rates for a 16% rate are as follows.

Present Value of $1 Ordinary Annuity of $1

Year 1 0.8621 0.8621
Year 2 0.7432 1.6052
Year 3 0.6407 2.2459

What is the net present value of this project?”

SOLUTION:

To determine the net present value of this project, set up an analysis of cash flows as follows:

Annual Annual Annual Annual

Before Tax Tax Aftertax Aftertax

Cash Flows Savings Cash Flow Net Income

Investment Year 0 (150,000) 0 (150,000) 0

Annual cash savings Year 1-3 85,000 (34,000) 51,000 51,000

Depreciation effect Year 1 18,000 18,000 (27,000)*

Year 2 24,000 24,000 (36,000)**

Year 3 18,000 18,000 (27,000)*

Gain on Disposal Year 3 10,000 (4,000) 6,000 6,000

These depreciation effects are calculated as follows:

Yr1 150,000 x .30 (depreciation) x .40 (tax rate) = 18,000

Yr2 150,000 x .40 (depreciation) x .40 (tax rate) = 24,000

Yr3 150,000 x .30 (depreciation) x .40 (tax rate) = 18,000

* 18,000 – (150,000 x .30 depreciation) = (27,000)

** 24,000 – (150,000 x .40 depreciation) = (36,000)

Now determine the Net Present Value of Annual Aftertax Cash Flow by year.

Annual Present Net

Aftertax Value Present

Cash Flow x of $1 = Value

Yrly Total: Yr 0 (150,000) x 1.0000 = (150,000)

Yr 1 (51,000 + 18,000) x 0.8621 = 59,485

Yr 2 (51,000 + 24,000) x 0.7432 = 55,740

Yr 3 (51,000 + 18,000 + 6,000) x 0.6407 = 48,053

Total 13,278′

Questions:

1. Depreciation: For the first year they calculate: ‘ 150 x 30% = 45000’

Shouldn’t it be (150000 – 10000 salvage) *30% ? why would they depreciate the salvage value?

2. I dont understand why they dont deduct last years depreciation in year 2 and 3:

They calculate ‘150 x 40%’ (year 2), ‘ Year 3 = 150 x 30%’

Why are they apply depreciaiton on the original cost amount every year?

I was taught that you have to deduct depreciation already applied on the cost amount:

Yr 2 = (150000 – 45000(from year 1)= 105,000 x 40% = 42,000 (pretax) dep for year 2

Yr 3 = (105000 – 42000(from year 1)= 63,000 x 30% = 18,900 (pretax) dep for year 3

3. Tax on salvage value

I’ve never seen anyone tax the salvage value before –> why on earth would they tax the resale value? I was taught to just discount the salvage value back to present state???

Thanks to those who reply!!

Havent decided when I will be writing BEC, FAR, REG, AUD

[Anonymous]

-Key here is that the question tells you the equipment is to be fully depreciated. This is true in practice for tax that we often depreciate items to zero, even though for practical purposes, we know they have value.
Year 1 depreciation $150,000* 30%= $45,000
Year 2 depreciation $150,000* 40%= $60,000
Year 3 depreciation $150,000* 30% = $45,000

After 3 years, the equipment has been fully depreciated. When we sell the equipment for $10,000 in year 3, this is a gain since our basis is zero. We have to pay tax on the gain.

Let me know if this makes sense.

[Felix The Cat]

Hi Chandler,

Thank you for your response. I do not understand your explanation.

So what you mean by ‘fully depreciated' Why is it not like straight line, where you deduct previous depreciated amounts from the orginal cost amount until you get to the end of the assets useful life?

and to repeat my question again, why are they applying depreciation on the full cost amount? (150000) why are they not deducting the salvage value from it (150 -10) ?

This is the first question I have seen in my career where previous depreciation is not deducted….thats like saying I have an asset with a useful life of 100 years………and in the 98year I am still applying depreciation on the original cost (150) —> doesnt make sense to me.

Have a great evening,

FTC

Havent decided when I will be writing BEC, FAR, REG, AUD

[Anonymous]

Hi @FTC, the question states that the equipment is to be fully depreciated. This means there will be zero residual Net book value when it it depreciated. You are over complicating this problem. It gives you the depreciation percents, so just multiply these times the original cost on each.
– As for your comment that previous depreciation not considered, that is not always an issue. Think about straight-line depreciation. A building that costs $100,000 and has a 50 year useful life will be depreciated $2,000 in year 1 and $2,000 in year 49.
– I understand why you want to include the salvage value in your calculation, but we don't do that in tax depreciation- we depreciate assets down to zero.

– Maybe this makes sense, let me know.

[Felix The Cat]

Hi Chandler,

Its really nice of you to stick around after you have long passed all your exams (Congrats!)

As for your comment about straight line depreciation:

I understand that you would be deducting 2000 in year 1 and year 49, however you would not be deducting it from the historical cost figure ( ie 100 ,000 – 2000 in year 49?! ). In year 49 it would be =100,000 – (48 x 2000) – 2000 .

This leads me back to my original question: why are they deducting depreciation from 150,000 (the historical cost ) in Year 3? that is unheard of.

Hope you are able to explain.

Thank You,

FTC.

Havent decided when I will be writing BEC, FAR, REG, AUD

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