CMA Study Group

Why sold Asset depreciation is including again

  • 1.  Why sold Asset depreciation is including again

    Posted 17 days ago

    Reference to the question below. Why is the depreciation of the sold asset being considered and adjusted to arrive at the after tax cash flow?
    Please respond and assist.

    Question ID: ICMA 1603.P2.069 (Topic: Capital Budgeting Process)

    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.

    Appreciate if any one can explain



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    Mohammed Khan
    Accountant
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  • 2.  RE: Why sold Asset depreciation is including again

    Posted 17 days ago
    Hello Mohammad,

    Hope you are safe & enjoying Capital Budgeting study

    The company had (2) available alternatives to chose between:
    1. Keep the old equipment for the next (2) remaining years of its life
    2. Dispose the old equipment and install a new one

    The management has decided to take the second option (Buy) >>> To give up the first one, which means a "Lost opportunity"
    When we calculate the annual net after-tax cash flows, we always take the concepts of "Incremental & Opportunity Cost" into consideration.
    The old equipment would be still in use for another (2) years if the company decided to keep it, which means there would be a cost saving of (2) years depreciation tax-shield to be added to annual net after-tax cash flows (For financial analysis purpose).
    Since the company has lost the opportunity of (2) years savings, we should subtract this loss from the new tax shield savings of the new equipment (The Incremental concept)

    Net incremental tax shield      = ( New depreciation - Old depreciation ) x Tax %
                                                         = [ ( $600,000 / 4 ) - ( $50,000 / 2 ) ] x 40%
                                                         = $50,000
    After-tax annual cash savings = $150,000 x (1 - 40%)
                                                         = $90,000
    Year (2) after-tax cash flow      = $90,000 + $50,000 = $140,000

    Key takeaway:
    When the existing equipment still has a useful life  >>>  Consider the opportunity cost of lost tax shield

    Hope this will be helpful

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

    Kind regards

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    Samer Ahmad, FMVA, SCA
    Kuwait
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  • 3.  RE: Why sold Asset depreciation is including again

    Posted 14 days ago
    Dear Samer,

    Well clarified.

    Thank you

    Tressa

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    TRESSA JOHN
    Executive Officer
    Kuwait
    Kuwait
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  • 4.  RE: Why sold Asset depreciation is including again

    Posted 13 days ago
    Samer Ahmad - thank you!  Such a beautiful yet simple explanation to clarify.

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    Cynthia Lopez
    Accountant
    Dallas TX
    United States
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  • 5.  RE: Why sold Asset depreciation is including again

    Posted 15 days ago
    well explained. thank you

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    Evalyne Aoko
    Student
    Dubai
    United Arab Emirates
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