Question

The U.S. government has decided to decrease the corporate tax rate from 35% to 20% (for the record, I originally wrote this problem long before this actually happened). You have been tasked with re-estimating the remaining PV of a project’s cash flows. The project will operate for the next 4 years before shutting down. It will produce yearly revenue of $40k with yearly operating costs of $20k. The project utilizes some heavy machinery which has a current book value of $80k and is being depreciated on a straight-line basis by $15k per year for the remainder of the project. (IMPORTANT: This does not mean that you purchase the machine today for $80k. You bought the machine in the past when you started the project). The machinery will have a resell value of $30k at the completion of the project. The firm’s discount rate is 10%.

2. Compute the after-tax salvage both before and after the tax change.

Answer 1

The after-tax salvage before the tax change will be as under:

And, the after-tax salvage after the tax change is as under:

Note: 1) We have first subtracted depreciation to calculate the profit. And, later we have added depreciation to calculate cash flows because depreciation is an expense but it does not result in cash outflow.

2) The value of the machinery at the end of 4th year will be $20,000 ($80,000 - ($15,0000 x 4)). So, when the machine was sold for $30,000. A profit of $10,000 was made. So, we have added this profit to calculate the total profit as we need to pay tax on this profit as well. And, later we have only added the cost of machine to calculate the cash flows.

3) Present values are calculated using the formula, P.V. = CF / (1+d/100)^t

where, CF = Cash Flow

d = discount rate

t = years