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Financial & Managerial Accounting
Found in: Page 1089
Financial & Managerial Accounting

Financial & Managerial Accounting

Book edition 7th
Author(s) John J Wild, Ken W. Shaw, Barbara Chiappetta
Pages 1096 pages
ISBN 9781259726705

Short Answer

Manning Corporation is considering a new project requiring a $90,000 investment in test equipment with no salvage value. The project would produce $66,000 of pretax income before depreciation at the end of each of the next six years. The company’s income tax rate is 40%. In compiling its tax return and computing its income tax payments, the company can choose between the two alternative depreciation schedules shown in the table.

Straight-Line MACRS

Depreciation Depreciation*

Year 1 . . . . . . . . . . $ 9,000 $18,000

Year 2 . . . . . . . . . . 18,000 28,800

Year 3 . . . . . . . . . . 18,000 17,280

Year 4 . . . . . . . . . . 18,000 10,368

Year 5 . . . . . . . . . . 18,000 10,368

Year 6 . . . . . . . . . . 9,000 5,184

Totals . . . . . . . . . . . $90,000 $90,000

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) straight-line depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

2. Prepare a five-column table that reports amounts (assuming use of MACRS depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) MACRS depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the income amount before depreciation minus the income taxes. (Round answers to the nearest dollar.)

3. Compute the net present value of the investment if straight-line depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

4. Compute the net present value of the investment if MACRS depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

Analysis Component

5. Explain why the MACRS depreciation method increases this project’s net present value.

The net cash flows are computed using both methods. The NPV using a straight line is $108,518 and NPV using MACRS is $110,303. MACRS shows an increased NPV because of the increased cash inflows.

See the step by step solution

Step by Step Solution

Step-by-Step SolutionStep 1: Preparation of table using straight-line depreciation

Year

Income before depreciation

Straight-line depreciation

Taxable Income

Income Taxes

Net Cashflows

Year 1

$66,000

$9,000

$57,000

$22,800

43,200

Year 2

66,000

18,000

48,000

19,200

46,800

Year 3

66,000

18,000

48,000

19,200

46,800

Year 4

66,000

18,000

48,000

19,200

46,800

Year 5

66,000

18,000

48,000

19,200

46,800

Year 6

66,000

9,000

57,000

22,800

43,200

Step 2: Preparation of table using MACRS depreciation

Year

Income before depreciation

Straight-line depreciation

Taxable Income

Income Taxes

Net Cashflows

Year 1

$66,000

$18,000

$48,000

$19,200

$46,800

Tear 2

66,000

28,800

37,200

14,880

51,120

Year 3

66,000

17,280

48,720

19,488

46,512

Year 4

66,000

10,368

55,632

22,253

43,747

Year 5

66,000

10,368

55,632

22,253

43,747

Year 6

66,000

5,184

60,816

24,326

41,674

Step 3: Computation of net present value (Straight-line method)

Charts Values are based on:
I = 10%

Year

Net Cash Inflow

X

PV Factor

=

Present Value

1

43,200

X

0.9091

=

39,273

2

46,800

X

0.8264

=

38,676

3

46,800

X

0.7513

=

35,161

4

46,800

X

0.6830

=

31,964

5

46,800

X

0.6209

=

29,058

6

43,200

X

0.5645

=

24,386

Present Value of cash inflows

$198,518

Present Value of cash outflows

-90,000

Net present value

$108,518

Step 4: Computation of net present value (MACRS)

Charts Values are based on:
I = 10%

Year

Net Cash Inflow

X

PV Factor

=

Present Value

1

46,800

X

0.9091

=

42,546

2

51,120

X

0.8264

=

42,246

3

46,512

X

0.7513

=

34,944

4

43,747

X

0.6830

=

29,879

5

43,747

X

0.6209

=

27,163

6

41,674

X

0.5645

=

23,525

Present Value of cash inflows$200,303
Present Value of cash outflows-90,000
Net present value$110,303

Step 5: MACRS depreciation increases the NPV of the project

The MACRS depreciation method increases the net present value of the project as shows higher depreciation in the early years which leads to an increase in the cash inflows. So, MACRS depreciation increases the NPV of the project.

Most popular questions for Business-studies Textbooks

Most Company has an opportunity to invest in one of two new projects. Project Y requires a $350,000 investment for new machinery with a four-year life and no salvage value. Project Z requires a $350,000 investment for new machinery with a three-year life and no salvage value. The two projects yield the following predicted annual results. The company uses straight-line depreciation, and cash flows occur evenly throughout each year.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $350,000 $280,000

Expenses

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000 35,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 42,000

Overhead including depreciation . . . . . . . . . . . . . . 126,000 126,000

Selling and administrative expenses . . . . . . . . . . . 25,000 25,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270,000 228,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 52,000

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 15,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 56,000 $ 36,400

Required

1. Compute each project’s annual expected net cash flows. (Round the net cash flows to the nearest dollar.)

2. Determine each project’s payback period. (Round the payback period to two decimals.)

3. Compute each project’s accounting rate of return. (Round the percentage return to one decimal.)

4. Determine each project’s net present value using 8% as the discount rate. For part 4 only, assume that cash flows occur at each year-end. (Round the net present value to the nearest dollar.) Analysis Component

5. Identify the project you would recommend to management and explain your choice.

Interstate Manufacturing is considering either replacing one of its old machines with a new machine or having the old machine overhauled. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.

Alternative 1: Keep the old machine and have it overhauled. If the old machine is overhauled, it will be kept for another five years and then sold for its salvage value.

Cost of old machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $112,000

Cost of overhaul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150,000

Annual expected revenues generated . . . . . . . . . . . . . . . . . . 95,000

Annual cash operating costs after overhaul . . . . . . . . . . . . . . 42,000

Salvage value of old machine in 5 years . . . . . . . . . . . . . . . . 15,000

Alternative 2: Sell the old machine and buy a new one. The new machine is more efficient and will yield substantial operating cost savings with more product being produced and sold.

Cost of new machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300,000

Salvage value of old machine now . . . . . . . . . . . . . . . . . . 29,000

Annual expected revenues generated . . . . . . . . . . . . . . . 100,000

Annual cash operating costs . . . . . . . . . . . . . . . . . . . . . . . 32,000

Salvage value of new machine in 5 years . . . . . . . . . . . . 20,000

Required 1. Determine the net present value of alternative 1.

2. Determine the net present value of alternative 2.

3. Which alternative do you recommend that management select? Explain.

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