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INITIAL INVESTMENTrefers to the relevant cash outflows considered when evaluating a prospective capital expenditure.
These are:• the installed cost of new asset• After Tax proceeds from sale of Old Asset• Change in next working capital
THE INSTALLED COST OF NEW ASSET
Installed Cost of New Asset- is the Cost of New Asset plus installation cost (if any)
• CNA= net outflow its acquisition requires• IC = any added costs necessary to
place an asset for operations
Example: Installed Cost of New AssetTable 11.1 The Cost of new Asset is the Net Outflow that its acquisition requires
Installation Costs are any added cost necessary to place an asset into Operation
Example: Cost of New Asset = $40,000 Installation Cost = 10,000 Then the Basic Initial Investment =$ 50,000 or the Depreciable Value
After Tax Proceeds from Sale of Old Asset
ATPSOA= is the difference between the old asset’s sale proceeds and any applicable taxes or tax refunds related to its sale
• Book Value=difference between installed cost and accumulated depreciation
• Basic Tax Rule =3 possible taxes: more than its BV’ for its BV; Less than its BV.
RECAPTURED DEPRECIATION• The portion of an asset’s sale price that is
above its book value and below its initial purchase price
• Example: if Hudson sells the old asset for $110,000 the gain is $62,000 or:
= $110,000 - $48,000 = $62,000Where: Recaptured Depreciation is $ 52,000
or and initial gain is $100,000 (IP)-$48,000(BV)
AFTER TAX PROCEEDS FROM SALE OF OLD ASSET
The after Tax proceeds from sale of old asset decrease the firm’s initial investment in the new asset.
These proceeds are the difference between the old asset’s sale proceeds and any applicable taxes or tax refunds related to sale.
The proceeds from sale of old asset are subject to type of tax
This Tax on sale of old asset depends on the relationship between its sale price and Book Value and on existing government tax rules
Tax Treatment on Sale of AssetsFORM OF tax
DEFINITION TAX TREATMENT
ASSUMED TAX RATW
GAIN PORTION OF SALE PRICE MORE THAN ITS BV
TAXED AS ORDINARY
INCOME
40%
LOSS ON SALE OF ASSET
AMOUNT IS LESS THAN ITS BOOK VALUE
If Depreciable and used in business, loss is DEDUCTEDIf not depreciable or not used in Business, loss is deductible only against CAPITAL GAINS.
40% OF LOSS IS Tax Savings
40% OF LOSS IS Tax Savings
STEP1. COMPUTE BOOK VALUE
The Book Value of an Asset is its strict accounting value.
Formula: Book Value= Installed Cost of Asset Less: Accumulated DepreciationCalculate: BV = $50,000 - $39,000 = $11,000Where: AD at the end of 2 years at 33% & 45%Is .33+.45 X $50,000 i= $39,000
EQUIVALENCIES ON % ACCUMULATED DEPRECIATION FOR RECOVERY YEARSRecovery Year 3 Years 5 Years 7 Years 10 Years
1 33% 20% 14% 10%2 45 32 25 183 15 19 18 144 7 12 12 125 12 9 96 5 9 87 9 78 4 69 6
10 611 4
In Page 169 these % are used in computing the Accumulated Depreciation
11.2 Hudson IndustriesUsing the 5 year recovery period the asset was being
depreciated in year 1 and 2 as follows: Book Value= $100,000 - $52,000 = $48,000Where:Cost of Recovery for year 1 & 2 is $52,000 computed
as follows: = .20+ .32 X $100,000 = .52 X $100,000 = $52,000
Discussion
Discussion
Illustration on Recovery period at the end of 4 years Book Value= $100,000 - $83,000
= $17,000Where: Cost of Recovery for year 1, 2, 3, & 4 = .20+.32+.19+.12 X $100,000 = .83 X $100,000 = $83,000
Discussion11.3 If Hudson Industries decides to sell the asset
which was purchased 2 years ago and its current Book Value is $48,000More than its Book Value = $110,000 - $48,000Total Gain Above Book Value = $62,000Where: Initial Purchase Price = $100,000- $48,000 Recaptured Depreciation = $52,000 (20%+32%) Both Recaptured Depreciation and Capital Gain Tax are Added Capital Gain is $10,000 + $52,000 = $62,000
Discussion
11.3 If Hudson Industries decides to sell the asset which was purchased 2 years ago and its current Book Value is $48,000
At its Present Book Value = $100,000 - $48,000No Gain No Loss = $62,000Where: Recaptured Depreciation = $100,000- $48,000 Recaptured Depreciation = $52,000 Computed as .20+.32 X $100,000 = $ 52,000
Discussion
11.3 If Hudson Industries decides to sell the asset for its Book Value or the Asset is sold at $48,000
NO GAIN OR LOSSBecause no Tax results from selling an Asset for
its Book ValueThere is no Tax Effect on the Initial Investment in
the New Asset
Discussion
11.3 If Hudson Industries decides to sell the asset for
less than its Book Value say for example $30,000THERE IS LOSS OF $18,000 = $48,000- $30,000 = $18,000 (Loss)
11.5 Powell CorporationUsing the 5 year recovery period the asset was being
depreciated in year 1,2 & 3 as follows:Book Value= $100,000 - $52,000 = $48,000Where:Cost of Recovery for year 1 & 2 = .20+ .32 X $100,000 = .52 X $100,000 = $52,000
Discussion
EXERCISES ON ACCUMULATED DEPRECIATION 11-2 pp 502
Recovery Year 10 Years Initial Investment Cost of Recovery Book Value1 10% $120,000 $12,000 108,000
2 18 $115,000 20,700 98,4003 14 $110,000 15,400 103,2004 12 $105,000 12,600 105,6005 9 $100,000 9,000 109,2006 8 $95,000 7,600 24,0007 7 $90,000 6,300 111,6008 6 $85,000 5,100 112,8009 6 $80,000 4,800 112,800
10 6 $75,000 4,500 112,80011 4 $70,000 2,800 115,200
$65,000 2,600 64,400$60,000 2,400 57,600$55,000 2,200 52,800
11.7 Find the Book Value (Answer B,C,D,E)
Asset Installed Cost Recovery Period Elapsed time Since Purchased
A 980,000 5 3B 40,000 3 2
C 96,000 5 4
D 400,000 5 1
E 1,500,000 10 5
A 980,000 5 320% .7132 = $980,000X .7119 = $695,800
= $980,000-$695,800 = $284,200
11.10 Change in Net Working CapitalCurrent Asset Current
LiabilitiesAccount Change
$920,000 $640,000 Accruals +45,000Machine Securities 0
Inventories -25,000Accounts Payable +75,000
Notes Payable 0Accounted Receivable +155,000
Cash +35,000 Present $ 920,000- 640,000 = $280,000Expected Change Net Working Capital = $155,000 + 35,000 + 75,000 + 45,000 = $310,000- 25,000 = $285,0002. Why change is relevant in determining initial Investment for proposed replacement action3. Would change in NWC enter into any of the other cash flow components that make up the relevant cash flows?
11.11 Calculating Initial Investment Vastine Medical, Inc.Cost of Asset
Computer
Present Value of
Comp System
Depreciation under MACRS 5 YR RECOVERY
Cost of New Comp System
Elapsed time Since Purchased
$375,000 20% $500,000 .52 X 375,000
200,000 32 = $195,000
1912125
Book Value $ 375,000- 195,000 = $180,000Gain Realized=200,000 – 180,000 = $20,000New System = $500,000 X .40 = $200,000After Tax = $500,000- 200,000 = $ 300,000
11.12 Calculating Initial Investment Basic Calculation Cushing Corporation.
Cost of Old
Machine
Present Value
Depreciation under MACRS 5 YR RECOVERY
Cost of New Machine + Installation
Cost
Elapsed time Since Purchased
$20,000 $28,000 20% $40,000 .71 X 20,00032 5,000 = $14,200
19 $45,00012 Tax40%= $18,000125
Book Value $ 20,000- 14,200 = $5,800Gain Realized=28,000 – 5,800 = $22,200New System = $45,000 X .40 = $18,000After Tax = $45,000-18,000 = $ 27,000
11.13 Initial Investment at Various Prices
Old Machine
Present Value
Depreciation under MACRS 5 YR RECOVERY
Cost of New Machine + Installation
Cost
Computed 5 yr
$10,000 $11,000 20% $24,000 .95 X 26,000
7,000 32 2,000 = $24,700
2,900 19 $26,000
1,500 12 Tax40%= $10,400125
Book Value $ 26,000- 24,700 = $1,300 a) Gain Realized = $11,000 – $10,000Gain Realized=28,000 – 5,800 = 1,000 = $22,200 b) = $7,000 – $10,000New System = $26,000 X .40 = ($3,000) = $10,400 c) = $ 2,900- 10,000After Tax = $26,000-10,400 = ($7,100) = $ 15,600 d) = ($8,500)
11.11 Calculating Initial InvestmentCurrent Asset Current
LiabilitiesAccount Change
920,000 640,000 Accruals +45,000Machine Securities 0
Inventories -25,000Accounts Payable +75,000
Notes Payable 0Accounted Receivable +155,000
Cash +35,000 Present $ 920,000- 640,000 = $280,000Expected Change in Initial Investment= $155,000 + 35,000 + 75,000 + 45,000 = $310,000- 25,000 = $285,000
Conclusions/ Generalization/Evaluation
• In finding the Book Value of an Asset, it needs the use of MARCS depreciation for applicable percentages on recovery periods and its elapsed time since its purchase. Deduct first the elapsed % before performing another ordinary tax deductions
Conclusions/ Generalization/Evaluation
• Calculating the change in Net Working Capital of a new machine to replace the old one is to use comparative Income and Expenses Summary as follows in Ex.11.6
year New Revenue Expenses year Old Revenue Expenses1 $2,520,000 $2,300,000 1 $2,200,000 $1,990,0002 $2,520,000 $2,300,000 2 $2,300,000 $2,110,0003 $2,520,000 $2,300,000 3 $2,400,000 $2,230,0004 $2,520,000 $2,300,000 4 $2,400,000 $2,250,0005 $2,520,000 $2,300,000 5 $2,250,000 $2,120,000
New Proposed Machine• Purchase Price= $380,000• Installation price= 20,000• Total Cost $400,000• 1st year = $400,000 X .20= $80,000• 2nd year= $400,000 X .32= $128,000• 3rd year= $400,000 X .19= $ 76,000• 4th year= $400,000 X .12= $ 48,000• 5th year= $400,000 X .12= $ 48,000• 6th year= $400,000 X .05= $ 20,000• $400,000
With Present Machine (old)
• 1st year = $240,000 X .12= $28,000• 2nd year= $240,000 X .12= $28,000• 3rd year= $240,000 X .05= $12,000• =$69,600
Operating Cash InflowsRevenue Less : Expenses (Excluding Depreciation and Interest)
Earnings before Depreciation, Interests and TaxesLess: Depreciation
Earnings Before Interest and TaxesLess: Taxes (rate=T)
Net Operating Profit after Taxes[NOPAT=EBIT X(1 – T)Add: Depreciation
Operating Cash Inflows (same as OCF in n Equation 4.3) pp 170
(Assignment)
• Check on the following exercises in your book- pages 502-514
• Compute the following and pass them next meeting: P11-12, P11-13, P11-16, P11-19
• Be ready for Quiz