The intention is to add salvage value portion for the year , that is the proportion of cash we get on sale at the end of life years.
Either deduct from equipment value so that only reduced depreication is added back, or full depreciation plus annual salvage value computed isbadded back to profit to compute the cash profit or cash available.
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Sreekanth Sasidharan Nair
Executive Officer
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Original Message:
Sent: 05-14-2020 08:02 PM
From: Bradley Kilbreth
Subject: Capital Budgeting Question
Owen Optical is evaluating a potential investment opportunity. The equipment is estimated to cost $1,200,000 with a five-year useful life and a salvage value of $80,000. Owen Optical uses the straight-line depreciation for all equipment. Management estimates that the investment will provide after-tax income of $367,000 per year. Owen's effective tax rate is 40%. Based on this information, what is the project's payback period?
Annual depreciation expense = (Asset cost – Salvage value) ÷ Estimated useful life = ($1,200,000 – $80,000) ÷ 5 = $224,000.
After-tax annual cash flow = After-tax income + Annual depreciation = $367,000 + $224,000 = $591,000.
Payback period = Initial investment outlay ÷ After-tax annual cash flow = $1,200,000 ÷ $591,000 = 2.0 years.
I have 2 questions.
1. Why is salvage value used in calculating depreciation expense?
2. Why is annual depreciation added back instead of the depreciation tax shield?
Thank you!!
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Bradley Kilbreth
Student
Manchester NH
United States
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