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Financial & Managerial Accounting
Found in: Page 1091
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

Grossman Corporation is considering a new project requiring a $30,000 investment in an asset having no salvage value. The project would produce $12,000 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 two alternative depreciation schedules as shown in the table.

Straight-Line MACRS

Depreciation Depreciation*

Year 1 . . . . . . . . . . $ 3,000 $6,000

Year 2 . . . . . . . . . . 6,000 9,600

Year 3 . . . . . . . . . . 6,000 5,760

Year 4 . . . . . . . . . . 6,000 3,456

Year 5 . . . . . . . . . . 6,000 3,456

Year 6 . . . . . . . . . . 2,000 1,728

Totals . . . . . . . . . . . $30,000 $30,000

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following items 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 items 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 amount of income 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 the net present value of this project.

The net cash flows are computed using both methods. The NPV using a straight line is $10,041 and NPV using MACRS is $10,635. 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

$12,000

$3,000

$9,000

$3,600

$8,400

Year 2

12,000

6,000

6,000

2,400

9,600

Year 3

12,000

6,000

6,000

2,400

9,600

Year 4

12,000

6,000

6,000

2,400

9,600

Year 5

12,000

6,000

6,000

2,400

9,600

Year 6

12,000

3,000

9,000

3,600

8,400

Step 2: Preparation of table using MACRS depreciation

Year

Income before depreciation

Straight-line depreciation

Taxable Income

Income Taxes

Net Cashflows

Year 1

$12,000

$6,000

$6,000

$2,400

$9,600

Tear 2

12,000

9,600

2,400

960

11,040

Year 3

12,000

5,760

6,240

2,496

9,504

Year 4

12,000

3,456

8,544

3,418

8,582

Year 5

12,000

3,456

8,544

3,418

8,582

Year 6

12,000

1,728

10,272

4,109

7,891

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

8,400

X

0.9091

=

7,636

2

9,600

X

0.8264

=

7,933

3

9,600

X

0.7513

=

7,212

4

9,600

X

0.6830

=

6,557

5

9,600

X

0.6209

=

5,961

6

8,400

X

0.5645

=

4,742

Present Value of cash inflows$40,041
Present Value of cash outflows-30,000
Net present value$10,041

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

$9,600

X

0.9091

=

8,727

2

11,040

X

0.8264

=

9,123

3

9,504

X

0.7513

=

7,140

4

8,582

X

0.6830

=

5,862

5

8,582

X

0.6209

=

5,329

6

7,891

X

0.5645

=

4,454

Present Value of cash inflows$40,635
Present Value of cash outflows-30,000
Net present value$10,635

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

Cortino Company is planning to add a new product to its line. To manufacture this product, the company needs to buy a new machine at a $300,000 cost with an expected four-year life and a $20,000 salvage value. All sales are for cash and all costs are out-of-pocket, except for depreciation on the new machine. Additional information includes the following.

Expected annual sales of new product . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,150,000

Expected annual costs of new product

Direct materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 420,000

Overhead (excluding straight-line depreciation on new machine) . . . . . . . . . . . . . . 210,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30%

Required

1. Compute straight-line depreciation for each year of this new machine’s life. (Round depreciation amounts to the nearest dollar.)

2. Determine expected net income and net cash flow for each year of this machine’s life. (Round answers to the nearest dollar.)

3. Compute this machine’s payback period, assuming that cash flows occur evenly throughout each year. (Round the payback period to two decimals.)

4. Compute this machine’s accounting rate of return, assuming that income is earned evenly throughout each year. (Round the percentage return to two decimals.)

5. Compute the net present value for this machine using a discount rate of 7% and assuming that cash flows occur at each year-end. (Hint: Salvage value is a cash inflow at the end of the asset’s life.)

Archer Foods has a freezer that is in need of repair and is considering whether to replace the old freezer with a new freezer or have the old freezer extensively repaired. Information about the two alternatives follows. Management requires a 10% rate of return on its investments.

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

Cost of old freezer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $75,000

Cost of repair . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Annual expected revenues generated . . . . . . . . . . . . . . . 63,000

Annual cash operating costs after repair . . . . . . . . . . . . . 55,000

Salvage value of old freezer in 8 years . . . . . . . . . . . . . . 3,000

Alternative 2: Sell the old freezer and buy a new one. The new freezer is larger than the old one and will allow the company to expand its product offerings, thereby generating more revenues. Also, it is more energy efficient and will yield substantial operating cost savings.

Cost of new freezer............................. $150,000

Salvage value of old freezer now.................. 5,000

Annual expected revenues generated . . . . . . . . . . . . . . 68,000

Annual cash operating costs . . . . . . . . . . . . . . . . . . . . . . 30,000

Salvage value of new freezer in 8 years . . . . . . . . . . . . . 8,000

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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