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MCQ-12012

Olson Industries needs to add a small plant to accommodate a special contract to supply building
materials over a five-year period. The required initial cash outlays at inception are as follows.

Land $500,000
New building 2,000,000
Equipment 3,000,000

Olson uses straight-line depreciation for tax purposes and will depreciate the building
over 10 years and the equipment over five years. Olson's effective tax rate is 40 percent.
Revenues from the special contract are estimated at $1.2 million annually, and cash expenses
are estimated at $300,000 annually. At the end of the fifth year, the assumed sales values of the
land and building are $800,000 and $500,000, respectively. It is further assumed that the
equipment will be removed at a cost of $50,000 and sold for $300,000.
As Olson utilizes the net present value (NPV) method to analyze investments, the net cash flow
for Year 5 would be:

A. $1,590,000.

B. $1,710,000.

C. $2,240,000.

D. $2,390,000.

Explanation

Choice “D” is correct. Cash flow calculations for capital budgeting analysis questions often
involve several different components. The focus is on actual cash dollars flowing into and
out of the company's "wallet," which will include revenues, cash expenses, taxes
(accounting for depreciation as a tax shield), and proceeds from the asset sales net of the
tax impact.
The net cash flow for Year 5, of $2,390,000, as shown below:

Line Item Amount

Revenues $1,200,000
Cash expenses (300,000)
Depreciation: (800,000)
Pretax income 100,000
Taxes (40% rate) (40,000)
Add back depreciation (noncash expense) 800,000
Cash flow prior to asset sales 860,000
Sale of land, net of tax 680,000

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11/18/22, 9:04 PM Find Question

Line Item Amount

Sale of building, net of tax 700,000
Sale of equipment, net of tax 150,000
Net cash flow $2,390,000

Notes:

Depreciation: Building ($2,000,000 / 10 years) of $200,000 + Equipment ($3,000,000 / 5

years) of $600,000 = $800,000
Sale of land, net of tax: $800,000 – [($800,000 – $500,000) × 40%] = $680,000
Sale of building, net of tax: $500,000 + $200,000 = $700,000
Sale price: $500,000
Book value (after five years): Cost of $2,000,000 – Accumulated depreciation of $1,000,000
(five years at $200,000 per year) = $1,000,000
Tax benefit from the loss: ($500,000 – $1,000,000) × 40% = $200,000
Sale of equipment, net of tax: $250,000 – $100,000 = $150,000
Sale price, net of costs: $300,000 – $50,000 = $250,000
Book value (after five years): $0 (fully depreciated)
Tax on gain: ($250,000 – $0) × 40% = $100,000

Choice “A” is incorrect. This answer choice fails to add back depreciation as a noncash expense.
Depreciation is used to calculate taxes owed, but as a noncash expense must be added back
after it is initially subtracted.

Choice “B” is incorrect. This answer choice incorrectly excludes the sale of land, net of tax.

Choice “C” is incorrect. This answer choice ignores the sale of equipment, net of tax.

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