CMA Study Group

part 2 capital budgeting

  • 1.  part 2 capital budgeting

    Posted 17 days ago
    Hello ,

    Calamity Cauliflower Corporation is considering undertaking a capital project.
    The company would have to commit $24,000 of working capital in addition to an immediate outlay of $160,000 for new equipment. The project is expected to generate $100,000 of annual income for 10 years. At the end of that time, the new equipment, which will be depreciated on a straight-line basis, is expected to have a salvage value of $10,000.
    The existing equipment that would be sold to make room for the project has a historical cost of $220,000 and accumulated depreciation of $208,000. It has an estimated remaining useful life of 2 years and the remaining carrying amount is being depreciated on a straight-line basis. A scrap dealer has agreed to buy it for $8,000.
    The company's effective tax rate is 40%.   Question: 31If the project is accepted, Calamity Cauliflower's expected net cash inflow at the end of the first year is
    A. $110,000
    B. $64,000
    C. $60,000
    D. $56,000

    The answer is b

    My question is why did he subtracted the tax shield of the old machine however it is sold ?

    Thanks in advance

  • 2.  RE: part 2 capital budgeting

    Posted 17 days ago
    Hello Nermin,

    Hope you are safe & doing great with Part-2

    This kind of questions is really "Crazy" ... You feel that someone is trying to make smart or attempting to fool you.
    Main argument is:
    • It is clearly mentioned that "Existing equipment that would be sold to make room for the project" so, there is no project at all if the old equipment is being kept for additional (2) years until it is 100% depreciated ????
    • Depreciation of old equipment !!! Is it relevant here ?? and should be considered in capital budgeting ???? 
    • Suppose that project will start after (2) years (When old equipment is 100 % "Depreciated") It is clearly mentioned that "A scrap dealer has agreed to buy it for $8,000" ... So, where is that money from project budget ??? Is it irrelevant ??? or it is not clear when the cash will be received !!! maybe after "10 years" ???

    "Crazy" assumptions of "Crazy" solution:
    • New project will start immediately (Despite the said fact of "room space" and replacement process)
    • Both equipment's salvage value are ignored in both accrual & cash flow basis ??!!!!
    • Net cash flow of first year = After-tax income + Tax shield of old equipment depreciation + Tax shield of new equipment depreciation

    Honestly speaking, I can understand any misleading information in CMA exam questions, but I can't accept such kind of crazy unrealistic assumptions. The only thing I can do is to consider it as "Accepted Risk" which is part of 140 remaining score.

    Wish you best of luck, success, safe & healthy condition

    Kind regards

    Samer Ahmad, FMVA, SCA

  • 3.  RE: part 2 capital budgeting

    Posted 16 days ago
    Hello Samer,

    Hope you are safe too ,Thank you so much for your support , time and analysis . I thought that I missed information in this case .

    best regards

    Nermin Egypt