CMA Study Group

Capital Budgeting Question

  • 1.  Capital Budgeting Question

    Posted 22 days ago
    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!!

    Bradley Kilbreth
    Manchester NH
    United States

  • 2.  RE: Capital Budgeting Question

    Posted 22 days ago
    Hi Mr Bradley Kilbreth,

    Answer to 1
    Salvage value will be removed from Asset cost while calculating depreciation because it is estimated resale value of an asset at the end of its useful life and depreciation is the reduction value of the asset over its useful life. So the amount of depreciation will be on that value which is being used by the company but not on that part which has resale value.

    To conclude, there is no need to depreciate on that value of the cost of the asset by which we estimate it to receive at the end of its useful life.

    In the given example: $80,000 shall be received at the end of its life. so the depreciation will be provided on the remaining value of the asset which shall be used by the Owen capital. i.e $1,120,000 ($1,200,000 – $80,000)

    Answer to 2
    The annual depreciation is added back because we need to arrive at cash flows. Depreciation is a Non-cash expense, hence it is added back to arrive at cash flows. Annual depreciation of $224,000 is added back to after-tax income because the after-tax income of  $367,000 is after deducting the depreciation expense and it should be added back to arrive at after-tax cash flows.

    In order to add back depreciation tax shield, the depreciation expenses should not have been deduced at the time of arriving at the after-tax income of $367,000.

    I hope I was clear.

    Mythra Varun

  • 3.  RE: Capital Budgeting Question

    Posted 22 days ago
    1. By Payback period, we intend to calculate the years/months within which we would be able to payback the equipment cost. For this, cash available each year is required.
    2. Given are cost of equipment, and the yearly profit after deducting yearly depreciation.
    3. For calculating yearly depreciation, total depreciation for the life of the equipment needs to be deducted by its life years.
    4. Salvage value is the cash we get on sale of the equipment at the end of the life years.
    5. To include the salvage value cash in the calculation, either we deduct it from the total depreciation, and find out reduced annual depreciation, or alternatively, you could add directly that salvage value for each year, found out by dividing total salvage value by life years of the equipment, and adding to the profit for the year along with the annual depreciation amount.
    6. It is pay back period calculation, and so the full non cash items need to be added back to the profit for the year, because such profit was calculated after deducting such non cash depreciation.

  • 4.  RE: Capital Budgeting Question

    Posted 22 days ago
    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.

    Sreekanth Sasidharan Nair
    Executive Officer