Question

1. i)How should you use operating costs when calculating incremental cash flows?

a) Do not subtract operating costs, and then subtract taxes on operating income before operating costs.

b)Subtract operating costs, calculate taxes off of that number, and then add them back.

c)Subtract taxes as though operating costs were not tax-deductible. Then subtract operating costs.

d) Subtract operating costs.

ii) At the end of a project, the equipment purchased at the beginning is expected to have a positive market value that is greater than the book value. How should the salvage value affect terminal cash flows?

a) Use the expected market value

b) Use the difference between the expected market value and the book value

c) Use the book value

d) Use the expected market value less the taxes incurred on the difference between the salvage value and the book value

iii) A company has new equipment costs of $2 million, which will be depreciated to zero using straight-line depreciation over 6 years. The company expects to bring in revenues of $7 million per year for 6 years with production costs of $1.8 million per year. If the company's tax rate is 48%, what are the incremental earnings (not cash flows) of this project in years 1-6? Enter your answer in dollars and round to the nearest dollar. (Also, SHOW HOW TO PUT IT IN THE TI-83 CALCULATOR)

Answer 1

Answer 1 : operating costs when calculating incremental cash flows = Do not subtract operating costs, and then subtract taxes on operating income before operating costs. this is So because all operating cost are not necessarily cash cost. While computing Cash flow statement, only cash cost are considered. Since income tax cost is operating cost and even involves cash outflow, it must be deducted.

Answer 2 : At the end of a project, the equipment purchased at the beginning is expected to have a positive market value that is greater than the book value. The realization on sale or disposal of such equipment should be taken as inflow in Cash inflows from Investing Activities. Use the expected market value.

Answer 3 :

Income Statement
	Amount in $
Revenue	7000000
Production Cost	1800000
Depreciation	333333
Gross Profit	4866667
Taxes	2336000
Net profit	2530667
years	6
Total Incremental Earnings	15184000