CMA Study Group

A company installed new equipment with a four-year useful life and no salvage value. The new equipment cost $600,000 and will generate pretax cash savings of $150,000 annually. Old equipment with a book value of $50,000 and a remaining life of two years was sold for $20,000 when the new equipment was purchased. The company uses straight-line depreciation and its effective income tax rate is 40%. The second year's relevant after-tax cash flow is

• A. $150,000.
• B. $110,000.
• C. $140,000.correct
• D. $90,000.

Correct Answer Explanation for C:

The second year's relevant after-tax cash flow is the after-tax operating cash savings plus the depreciation tax shield.

The annual after-tax operating cash savings is $150,000 × (1 − 0.40), which equals $90,000.

The depreciation tax shield for the second year is 40% of the difference between what the depreciation would have been on the old equipment, had it been kept, and the depreciation on the new equipment. The depreciation on the old equipment, had it been kept, would have been $50,000 ÷ 2 remaining years of life, or $25,000. The depreciation on the new equipment is $600,000 ÷ 4, or $150,000. The difference, or the incremental depreciation expense, is $125,000. The depreciation tax shield is 40% of $125,000, or $50,000.

The second year's relevant after-tax cash flow is $90,000 + $50,000 = $140,000.

A company installed new equipment with a four-year useful life and no salvage value. The new equipment cost $600,000 and will generate pretax cash savings of $150,000 annually. Old equipment with a book value of $50,000 and a remaining life of two years was sold for $20,000 when the new equipment was purchased. The company uses straight-line depreciation and its effective income tax rate is 40%. The second year's relevant after-tax cash flow is

• A. $150,000.
• B. $110,000.
• C. $140,000.correct
• D. $90,000.

Correct Answer Explanation for C:

The second year's relevant after-tax cash flow is the after-tax operating cash savings plus the depreciation tax shield.

The annual after-tax operating cash savings is $150,000 × (1 − 0.40), which equals $90,000.

The depreciation tax shield for the second year is 40% of the difference between what the depreciation would have been on the old equipment, had it been kept, and the depreciation on the new equipment. The depreciation on the old equipment, had it been kept, would have been $50,000 ÷ 2 remaining years of life, or $25,000. The depreciation on the new equipment is $600,000 ÷ 4, or $150,000. The difference, or the incremental depreciation expense, is $125,000. The depreciation tax shield is 40% of $125,000, or $50,000.

The second year's relevant after-tax cash flow is $90,000 + $50,000 = $140,000.

A company installed new equipment with a four-year useful life and no salvage value. The new equipment cost $600,000 and will generate pretax cash savings of $150,000 annually. Old equipment with a book value of $50,000 and a remaining life of two years was sold for $20,000 when the new equipment was purchased. The company uses straight-line depreciation and its effective income tax rate is 40%. The second year's relevant after-tax cash flow is

• A. $150,000.
• B. $110,000.
• C. $140,000.correct
• D. $90,000.

Correct Answer Explanation for C:

The second year's relevant after-tax cash flow is the after-tax operating cash savings plus the depreciation tax shield.

The annual after-tax operating cash savings is $150,000 × (1 − 0.40), which equals $90,000.

The depreciation tax shield for the second year is 40% of the difference between what the depreciation would have been on the old equipment, had it been kept, and the depreciation on the new equipment. The depreciation on the old equipment, had it been kept, would have been $50,000 ÷ 2 remaining years of life, or $25,000. The depreciation on the new equipment is $600,000 ÷ 4, or $150,000. The difference, or the incremental depreciation expense, is $125,000. The depreciation tax shield is 40% of $125,000, or $50,000.

The second year's relevant after-tax cash flow is $90,000 + $50,000 = $140,000.

A company installed new equipment with a four-year useful life and no salvage value. The new equipment cost $600,000 and will generate pretax cash savings of $150,000 annually. Old equipment with a book value of $50,000 and a remaining life of two years was sold for $20,000 when the new equipment was purchased. The company uses straight-line depreciation and its effective income tax rate is 40%. The second year's relevant after-tax cash flow is

• A. $150,000.
• B. $110,000.
• C. $140,000.correct
• D. $90,000.

Correct Answer Explanation for C:

The second year's relevant after-tax cash flow is the after-tax operating cash savings plus the depreciation tax shield.

The annual after-tax operating cash savings is $150,000 × (1 − 0.40), which equals $90,000.

The depreciation tax shield for the second year is 40% of the difference between what the depreciation would have been on the old equipment, had it been kept, and the depreciation on the new equipment. The depreciation on the old equipment, had it been kept, would have been $50,000 ÷ 2 remaining years of life, or $25,000. The depreciation on the new equipment is $600,000 ÷ 4, or $150,000. The difference, or the incremental depreciation expense, is $125,000. The depreciation tax shield is 40% of $125,000, or $50,000.

The second year's relevant after-tax cash flow is $90,000 + $50,000 = $140,000.