Question

Ducks inc has provided the following data to be used to evaluate a proposed investment project:

                        Investment $880,000

                        Annual Cash Receipt $660,000

                        Life of the project 8 years

                        Annual cash expenses $330,000

                        Salvage value $88,000

                        Tax rate 30%

For tax purpose the entire initial investment without any reduction for salvage value will be depreciated over 7 years. The company uses a discount rate of 12%.

1. When computing the net present value of the project, what are the annual after-tax cash expense before discounting?

1. $462,000
2. $396,000
3. $198,000
4. $69,300

2. When computing the net present value of the project, what are the annual after-tax cash expenses after discounting?

1. 429,000
2. $242,000
3. $99,000
4. $231,000

3. When computing the net present value of the project, what is the annual amount of the depreciation tax-shield? In other words, by how much does the depreciation deduction reduce taxes each year in which the depreciation deduction reduce taxes each year in which the depreciation deduction is taken?

1. $37,714
2. $242,000
3. $99,000
4. $231,000

4. When computing the net present value of the project, what is the after-tax cash from the salvage value in the final year

1. $0
2. $88,000
3. $26,400
4. $61,600

Answer 1

1) Annual after tax cash expense before discounting is

Annual Cash Expense = $330,000

Annual Cash Expense after tax before discounting = $330,000 * 70% = $231,000

because the cash expense reduces the tax burden by $330,000 * 30% = $99,000

answer not there in the options

2) Annual after tax cash expenses after discounting is different for different years due to present value factor for different years.

3) Answer a - $37,714

Annual Amount of Depreciation Tax Shield = ( Investment - Salvage Value ) / No of years depreciated *30%

                                                              = ($880,000 - 0 ) / 7 * 30% = $37,714

4) Answer d - $61,600

After-tax cash from the salvage value in the final year = Salvage Value * 70% = $88,000 * 70% = $61,600

Even though the company considers salvage value as 0 for tax purposes, salvage value is still be received at the end of the final year, hence it should be considered.