Question

The characteristics of the proposed purchase plan of a new piece of equipment are as following:

Initial capital cost = HK$ 5000

Useful life = 5 years

Salvage value = 0

Expected annual income = 6000 - 100 j (j = 1, 2, 3, 4, 5 years)

Expected annual disbursements = 950 + 50 j

(1)Tabulate the cash flows after tax if the effective tax rate is 20% and the straight line depreciation method is used.

(2) If the "Double-Declining-Balance Method" and the "Sum-of-Years'-Digits Method" are used for the calculation of the depreciation, please tabulate the cash flows before tax, the annual depreciation, the annual tax, and the cash flows after tax. And compare the accumulated depreciations in the end of the 5th year between these two methods.

Based on the above questions, please investigate and comment that how the "effective tax rate" and its variation will affect the results of the above questions. For example, the "effective tax rate" varies +/- 0~0.05 based on the original 0.20 (i.e. the effective tax rate varies in the range between 15%~25%). (* two-page report is required)

Answer 1

A) Cash flows if Straight Line method is used.

Particulars	Y1	Y2	Y3	Y4	Y5
Expected Annual Income (6000 - 100j)	5900	5800	5700	5600	5500
(-) Expected Annual Disbursements (950 + 50j)	1000	1050	1100	1150	1200
Profit before Depreciation & Tax (PBDT)	4800	4750	4600	4450	4300
(-) Depreciation	1000	1000	1000	1000	1000
Profit Before Tax (PBT)	3800	3750	3600	3450	3300
(-) Tax @20%	760	750	720	690	660
Profit After Tax (PAT)	3040	3000	2880	2760	2640

Calculation of Depreciation :

Initial Capital cost = 5000

Salvage value = 0

Useful Life = 5 years

Deprecation = (5000-0)/5 years = 1000 per annum

B) Cash flows if Double Declining balance method is used.

Particulars	Y1	Y2	Y3	Y4	Y5
Expected Annual Income (6000 - 100j)	5900	5800	5700	5600	5500
(-)Expected Annual Disbursements (950 + 50j)	1000	1050	1100	1150	1200
Profit before Depreciation & Tax (PBDT)	4800	4750	4600	4450	4300
(-)Depreciation	2000	1200	720	432	259.2
Profit Before Tax (PBT)	2800	3550	3880	4018	4040.8
(-)Tax @20%	560	710	776	803.6	808.16
Profit After Tax (PAT)	2240	2840	3104	3214.4	3232.64

Calculation of Depreciation :

Initial Capital cost = 5000

Salvage value = 0

Useful Life = 5 years

SLM rate = (1000/5000)*100 = 20%

Deprecation rate = 2*SLM Rate = 40%

Particulars	Y1	Y2	Y3	Y4	Y5
Opening Book Value	5000	3000	1800	1080	648
(-)Depreciation @40%	2000	1200	720	432	259.2
Closing Book Value	3000	1800	1080	648	388.8

C) Cash flows if Sum of Years digits method is used.

Particulars	Y1	Y2	Y3	Y4	Y5
Expected Annual Income (6000 - 100j)	5900	5800	5700	5600	5500
(-) Expected Annual Disbursements (950 + 50j)	1000	1050	1100	1150	1200
Profit before Depreciation & Tax (PBDT)	4800	4750	4600	4450	4300
(-) Depreciation	1667	1333	1000	667	333
Profit Before Tax (PBT)	3133	3417	3600	3783	3967
(-) Tax @20%	626.6	683.4	720	756.6	793.4
Profit After Tax (PAT)	2506.4	2733.6	2880	3026.4	3173.6

Calculation of Depreciation

Initial Capital cost = 5000

Salvage value = 0

Useful Life = 5 years

Deprecation = (Remaining useful life/sum of years digits)*Depreciable cost

Sum of years digits = 5+4+3+2+1 = 15

Y1 - Depreciation = (5/15)*5000 = 1667

Y2 - Depreciation = (4/15)*5000 = 1333

Y3 - Depreciation = (3/15)*5000 = 1000

Y4 - Depreciation = (2/15)*5000 = 667

Y5 - Depreciation = (1/15)*5000 = 333

Particulars	Y1	Y2	Y3	Y4	Y5
Opening Book Value	5000	3333	2000	1000	333
(-)Depreciation	1667	1333	1000	667	333
Closing Book Value	3333	2000	1000	333	0

D) Comparison of accumulated Depreciations in the end of the th year between above two methods.

Accumulated Depreciations at the end of th year,

As per Sum of years digits method = 1667+1333+1000+667+333 = 5000

As per double declining balance method = 2000+1200+720+432+259.2 = 4611.2

So under Sum of years digits method full asset was depreciated. In case of double declining balance method asset was depreciated up to 4611.2 leaving behind asset's cost of 388.8