Hello Mohammad,
Hope you are safe & enjoying Capital Budgeting study
The company had (2) available alternatives to chose between:
- Keep the old equipment for the next (2) remaining years of its life
- 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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Original Message:
Sent: 06-19-2020 04:43 PM
From: Mohammed Khan
Subject: Why sold Asset depreciation is including again
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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