[NinaSun]

I am really confused by several BEC questions regarding payback method and involve depreciation expense.

Question 1:

Harvey Co. is evaluating a capital investment proposal for a new machine. The investment proposal shows the following information:

Initial cost $500,000

Life 10 years

Annual net cash inflows 200,000

Salvage value 100,000

If acquired, the machine will be depreciated using the straight-line method. The payback period for this investment is:

a. 2.67 years

b. 2.5 years

c. 3.25 years

d. 2 years

The answer is 2.5 years, using initial cost $500,000 divided by $200,000 annual net cash inflow. They said this question not considering depreciation expense, because depreciation expense only considered when it is a tax shield. So, how do I know in this question the depreciation expense is not a tax shield?

Question 2:

Kuchman Kookies has invested $100,000 in new ovens to improve their baking and production production process. The oven have a useful life of 5 years with no salvage value. The tax rate is 20%. The after-tax cash flows from the investment are expected to be as follows:

Year 1 $35,000

Year 2 38,000

Year 3 25,000

Year 4 20,000

Year 5 10,000

If the company uses an 8% hurdle rate for this investment. what is the payback period in years for the ovens?

a. 4.7

b. 4.0

c. 3.1

d. 2.3

The answer is 3.1. They just use the after-tax cash flow under cumulative approach to get the payback period. My question is why they dont add the tax shield? Or the tax shield already included in the after tax cash flow?

Question 3

A company invested in a new machine that will generate revenues of $35,000 annually for seven years. The company will have annual operating expense of $7000 on the new machine. Depreciation expense, included in operating expense, is $4,000 per year. The expected payback period for the new machine is 5.2 years. What amount did the company pay for the new machine?

a. $182,000

b. $166,400

c. $145,600

d. $161,200

The answer is b. In this question, they consider the depreciation expense and add it back to annual cash inflow (annual cash inflow=35000-7000+4000=32000) and then get the initial cost. Why this time consider depreciation cost. What is the difference between this one and the other two questions?

I appreciate any one can clear this confusing. BTW, how do you copy paste Becker MC on this board? It is really a lot works typing so many words.

AUD-74,75 11/2014
REG-80 04/2015
FAR-74, 91 11/2015
BEC-79 08/2015

[spatel15]

Depreciation Expense if you notice never effects this. Its a noncash expense. Payback period is just how many years it takes for your undiscounted inflows to equal your investment cost

As for the tax shelter comment, if perhaps one year cash inflows are less than depreciation expense, you'd have an loss. And you get tax benefits from losses. Still a non cash item though.

[LoneMount]

Can you find a tax rate in question 1? I think that's the easiest way to solve your question.

In question 3, by adding back depreciation expense, they are actually NOT considering it. So the rule of thumb is when you got a tax rate, you consider depreciation, otherwise, “ignore” it. By “ignore”, I mean do not include it in your calculation.

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[spatel15]

In 1, Inflows are 200K a year, depreciation is 40k. No tax benefit.

Problem 2 comes close, but not really, Year 5 you'd have a tax benefit but thats over a year after ya made your money back in terms of payback period.

Problem 3 you gotta know depreciation is noncash, doesn't mess with your returns, can never hurt your return at least. If its greater than the cash inflows, then sure it could provide a tax benefit, similar to the way net losses do.

[NinaSun]

Thank you @LoneMount and @spatel15. Your explanation make sense. So, for question two. the “after-tax cash flow” considered depreciation expense?

AUD-74,75 11/2014
REG-80 04/2015
FAR-74, 91 11/2015
BEC-79 08/2015

[Sandia]

Hi there,

Any idea why the Q2 do not use depreciation? Thank u

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[Anonymous]

@Sandia: refer to NinaSun's comment right above yours. Question 2 says the cash flows provided are after-tax, which means depreciation has already been accounted for in the numbers.

Regarding the topic question, depreciation is almost always included in the calculation. Unless the company has a net loss (or breaks even) the depreciation is going to cause a decrease in tax liability which is an incremental cash inflow. The key in question 1 is that it gives you net cash inflows, which means all inflows, thus any depreciation tax shield must be included. For question 2, the cash flows are given after-tax, which means depreciation has already been factored in. Depreciation's significance is that it affects taxes, so if you're given after-tax numbers you know it's already been included.

It's not that depreciation isn't adding to cash inflows in questions 1 and 2, it's that you're given numbers that already factor depreciation tax shield effects in.

[Sandia]

@ BOBRobbins great!! Thank you!!

FAR - 77 x2 Wiley book & no test bank
AUD - 83 x3 NINJA Test bank 3 time
REG - 80 x1 NINJA Test bank
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[Author]

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