Question

The Gastineau Girls are building a factory in Massachusetts to produce furry faux fur purses. The factory costs $10 million today (year 0) and will be (straight-line) depreciated to $0 over ten years (years 1-10). At the end of five years, the building will have a market value of $4 million. At the end of ten years, it will have a market value of $1 million. The corporate tax rate is 40%. What is the salvage value associated with selling the building at the end of year 5? What is the salvage value associated with selling the building at the end of year 10? (Assume that, ignoring this transaction, the Gastineau Girl’s fashion empire generates a taxable annual income in excess of $5 million.)

Answer 1

Book value of the Building will be $5 million(after deducting depreciation for 5 years) but market value is $4 million.

Salvage value is the value what we are going to receive after selling the building and tax.

in the first case we are charging less depreciation, which increases our taxable income , which means we paid more tax in the past , so we will get the tax return.

after tax salvage value = market value+(book value-market value)*tax-rate

After tax salvage value after five years =4+(5-4)*0.4

=4.4$ million

similarly in 2nd case book value is less than market value which means there will be capital gain and we have to pay the taxes (In other words we charged more depreciation)

after tax salvage value = market value+(book value-market value)*tax-rate

after tax salvage value after 10 years= 1+(0-1)*0.4

=1-0.4

=0.6$million

Note: we ignored that taxable annual income in excess for 5$ million , we are just bother about the assets and its value not about the operating income of Gastineu Girls, we have to ignore this point