Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

Chapter 13 Appendix C
Income Taxes in Capital Budgeting Decisions

Exercise 13C-1 (20 minutes)

Items and Computations

Project A:
Investment in photocopier .............
Annual net cash inflows ................
Depreciation deductions* ..............
Salvage value of the photocopier.....
Net present value .........................
Project B:
Investment in working capital ........
Annual net cash inflows ................
Release of working capital .............
Net present value .........................

Year(s)

(1)
Amount

(2)
Tax
Effect

(1) (2)
Present
After-Tax
Value of
Cash
10%
Cash
Flows Factor Flows

Now
1-8
1-8
8

$(50,000)

$9,000 1 0.30
$6,250
0.30
$5,000 1 0.30

$(50,000)
$6,300
$1,875
$3,500

Now
1-8
8

$(50,000)

$9,000 1 0.30
$50,000

$(50,000) 1.000 $(50,000)

$6,300 5.335 33,611
$50,000 0.467 23,350
$ 6,961

13C-1

1.000 $(50,000)
5.335 33,611
5.335 10,003
0.467
1,635
$( 4,751)

Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

* $50,000 8 years = $6,250 per year

Exercise 13C-2 (20 minutes)
1. Annual cost of student help in collating ...........
Annual cost of the new collating machine:
Operator ....................................................
Maintenance ..............................................
Annual net cost savings (cash inflow) ..............

$60,000
$18,000
7,000

2. The net present value analysis follows:

Items and Computations

Cost of the new collating machine ....

Annual net cost savings (above) .......
Depreciation deductions* .................
Cost of the new roller pads ..............
Salvage value of the new machine ....
Net present value............................

Year(s)
Now
1-10
1-10
5
10

(1)
Amount

25,000
$35,000

(2)
Tax
Effect

$(140,000)
$35,000 1 0.30
$14,000 0.30
$(20,000) 1 0.30
$40,000 1 0.30

* $140,000 10 years = $14,000 per year

Yes, the new collating machine should be purchased.

13C-2

(1) (2)
Present
After-Tax 14%
Value of
Cash Flows Factor Cash Flows
$(140,000)
$24,500
$4,200
$(14,000)
$28,000

1.000 $(140,000)
5.216
127,792
5.216
21,907
0.519
(7,266)
0.270
7,560
$ 9,993

Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

Exercise 13C-3 (10 minutes)

1. Management consulting fee.......
Multiply by 1 0.30 ..................
After-tax cost ...........................

$100,000
0.70
$ 70,000

2. Increased revenues ..................

Multiply by 1 0.30 ..................
After-tax cash flow (benefit)......

$40,000
0.70
$28,000

3. The depreciation deduction is $210,000 7 years = $30,000 per year,

which has the effect of reducing taxes by 30% of that amount, or
$9,000 per year.

13C-3

Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

Problem 13C-4 (20 minutes)

Items and Computations

Investment in new trucks.................

Salvage from sale of the old trucks ...
Annual net cash receipts ..................
Depreciation deductions* .................
Overhaul of motors .........................
Salvage from the new trucks ............
Net present value............................

Year(s)
Now
Now
1-8
1-8
5
8

(1)
Amount

$(450,000)
$30,000
$108,000
$56,250
$(45,000)
$20,000

(2)
Tax
Effect
1 0.30
1 0.30
0.30
1 0.30
1 0.30

(1) (2)
Present
After-Tax 12%
Value of
Cash Flows Factor Cash Flows
$(450,000)
$21,000
$75,600
$16,875
$(31,500)
$14,000

1.000 $(450,000)
1.000
21,000
4.968
375,581
4.968
83,835
0.567
(17,861)
0.404
5,656
$ 18,211

* $450,000 8 years = $56,250 per year

Because the project has a positive net present value, the contract should be accepted.

13C-4

Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

Problem 13C-5 (45 minutes)

Items and Computations

Alternative 1:
Investment in the bonds .........
Interest on the bonds
(8% $200,000) .................
Maturity of the bonds..............
Net present value ...................

Year(s)

(1)
Amount

Now

$(200,000)

1-12
12

$16,000
$200,000

(2)
(1) (2)
Tax
After-Tax
8% Present Value
Effect Cash Flows Factor of Cash Flows
$(200,000) 1.000 $(200,000)
$16,000
$200,000

7.536
0.397

120,576
79,400
$(
24) *

* This amount should be zero; the difference is due to rounding of the discount factors. (Because
the bonds yield 8% after taxes, they would have a zero net present value at an 8% discount
rate.)

13C-5

Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

Problem 13C-5 (continued)

Items and Computations

Alternative 2:
Investment in the business ..............
Annual net cash receipts
($400,000 $370,000 = $30,000) .
Depreciation deductions:
Year 1: 14.3% of $80,000 .............
Year 2: 24.5% of $80,000 .............
Year 3: 17.5% of $80,000 .............
Year 4: 12.5% of $80,000 .............
Year 5: 8.9% of $80,000 ............
Year 6: 8.9% of $80,000 ............
Year 7: 8.9% of $80,000 ............
Year 8: 4.5% of $80,000.............
Recovery of working capital
($200,000 $80,000 = $120,000) .
Net present value ...........................

Year(s)

(1)
Amount

(2)
Tax
Effect

Now

$(200,000)

1-12

$30,000 1 0.40

1
2
3
4
5
6
7
8

$11,440
$19,600
$14,000
$10,000
$7,120
$7,120
$7,120
$3,600

0.40
0.40
0.40
0.40
0.40
0.40
0.40
0.40

12

$120,000

13C-6

(1) (2)
Present
After-Tax
8%
Value of
Cash Flows Factor Cash Flows
$(200,000) 1.000 $(200,000)
$18,000

7.536

135,648

$4,576
$7,840
$5,600
$4,000
$2,848
$2,848
$2,848
$1,440

0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540

4,237
6,719
4,446
2,940
1,939
1,794
1,660
778

$120,000 0.397

47,640
$ 7,801

Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

The net present value of Alternative 2 is higher than the net present value of Alternative 1. That
certainly gives the edge to Alternative 2. However, the additional net present value is so small that it
may be outweighed by the higher risk of Alternative 2 and the potential hassles of owning a store.

13C-7

Chapter 13 Appendix C Income Taxes in Capital Budgeting Decisions

Problem 13C-6 (30 minutes)

1. The net present value analysis would be:

Items and Computations

Investment in equipment .............

Working capital needed ...............
Annual net cash receipts ..............
Depreciation deductions ..............
Cost of restoring land ...................
Salvage value of the equipment* ...
Working capital released ..............
Net present value........................

Year(s)
Now
Now
1-10
1-10
10
10
10

(1)
Amount

$(600,000)
$(85,000)
$110,000 1
$60,000
$(70,000) 1
$90,000 1
$85,000

(2)
Tax
Effect
0.30
0.30
0.30
0.30

(1) (2)
Present
After-Tax 10%
Value of
Cash Flows Factor Cash Flows
$(600,000)
$(85,000)
$77,000
$18,000
$(49,000)
$63,000
$85,000

1.000 $(600,000)
1.000
(85,000)
6.145
473,165
6.145
110,610
0.386
(18,914)
0.386
24,318
0.386
32,810
$( 63,011)

*$600,000 15% = $90,000.

2. No, the investment project should not be undertaken. It has a negative net present value.

13C-8