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Chapter 12: Problem 3

Net salvage value Kennedy Air Services is now in the final year of a project. The equipment originally cost \(\$ 20\) million, of which 80 percent has been depreciated. Kennedy can sell the used equipment today for \(\$ 5\) million, and its tax rate is 40 percent. What is the equipment's after-tax net salvage value?

Short Answer

Expert verified
The after-tax net salvage value is \(\$ 4,600,000\).

Step by step solution

01

Calculate Accumulated Depreciation

The equipment originally cost \(\\( 20\) million, and 80% of that has been depreciated. So, the accumulated depreciation is:\[\text{Accumulated Depreciation} = 0.8 \times 20,000,000 = \\) 16,000,000\]
02

Compute Book Value of the Equipment

The book value is the original cost minus accumulated depreciation. Therefore, the book value is:\[\text{Book Value} = 20,000,000 - 16,000,000 = \$ 4,000,000\]
03

Calculate the Gain on Sale

The gain on the sale is the market value minus the book value. Here, the market value (selling price) is \\( 5 million:\[\text{Gain on Sale} = 5,000,000 - 4,000,000 = \\) 1,000,000\]
04

Determine Tax on Gain

The tax on the gain from the sale needs to be computed. With a tax rate of 40%, the tax owed will be:\[\text{Tax on Gain} = 1,000,000 \times 0.4 = \$ 400,000\]
05

Calculate After-Tax Net Salvage Value

Subtract the tax on the gain from the sale value to find the net salvage value after tax:\[\text{After-Tax Net Salvage Value} = 5,000,000 - 400,000 = \$ 4,600,000\]

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Depreciation
Depreciation is a method used in accounting to spread the cost of a tangible asset over its useful life. This concept helps in understanding the gradual reduction of an asset's value over time due to wear and tear, usage, or obsolescence. Depreciation is crucial for determining an asset's book value at any point in time. For Kennedy Air Services, 80% of the equipment's original cost has been depreciated. This means that the company recognized a cost reduction of the equipment over the years totaling 80% of its original price.
It's important to choose an appropriate depreciation method, as it impacts financial statements and tax calculations. Some common methods include:
  • Straight-Line Depreciation: Equal depreciation expense every year
  • Declining Balance Method: Higher depreciation in earlier years
  • Units of Production: Depreciation based on usage or output
In this scenario, calculating depreciation gives an accumulated depreciation of $16 million, which is subtracted from the equipment's original cost to determine its book value.
Book Value
Book Value is essentially the net value of an asset that appears on a company's balance sheet. It represents the original cost of the asset minus its accumulated depreciation. In other words, it is the value left in the asset after considering its depreciation.For Kennedy Air Services, the equipment had an original cost of \( \\(20 \text{ million} \). After depreciating 80% of its cost, the remaining book value becomes \( \\)4 \text{ million} \).
Why is Book Value Important?
  • It indicates the current worth of an asset in accounting terms, which might differ from market value.
  • Helps in calculating gain or loss when the asset is sold.
  • Influences investment decisions as it reflects asset depreciation over time.
In our specific example, knowing the book value helps determine the financial impact of selling the equipment.
Tax Calculation
Tax Calculation related to asset sales is a key component in determining the after-tax cash flow from the sale. When a company sells an asset, any difference between the book value and the selling price results in a gain or a loss. This gain is often taxable, and thus, the tax on the gain must be calculated to determine the exact net cash flow from the sale.For Kennedy Air Services, the selling price of the asset is \( \\(5 \text{ million} \), while the book value is \( \\)4 \text{ million} \). This leads to a gain of \( \\(1 \text{ million} \). With a tax rate of 40%, the tax on the gain comes to \( \\)400,000 \).
Why Calculate Tax?
  • It determines the actual financial benefit, or net gain, from selling an asset.
  • Helps in financial forecasting and planning by understanding tax obligations.
  • Integral to obtaining the after-tax net salvage value, ensuring compliance with tax regulations.
The net salvage value after deducting taxes provides a clearer picture of the financial outcome from the asset sale.

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Most popular questions from this chapter

New project analysis You must evaluate a proposed spectrometer for the \(\mathrm{R\&D}\) department. The base price is \(\$ 140,000\), and it would cost another \(\$ 30,000\) to modify the equipment for special use by the firm. The equipment falls into the MACRS 3 -year class and would be sold after 3 years for \(\$ 60,000\). The applicable depreciation rates are 33,45 \(15,\) and 7 percent as discussed in Appendix 12 A. The equipment would require an \(\$ 8,000\) increase in working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm \(\$ 50,000\) per year before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40 percent. a. What is the net cost of the spectrometer, that is, what is the Year 0 project cash flow? b. What are the net operating cash flows in Years \(1,2,\) and \(3 ?\) c. What is the terminal cash flow? d. If the WACC is 12 percent, should the spectrometer be purchased?

Project risk analysis The Butler-Perkins Company (BPC) must decide between two mutually exclusive projects. Each costs \(\$ 6,750\) and has an expected life of 3 years. Annual project cash flows begin 1 year after the initial investment, and are subject to the following probability distributions: BPC has decided to evaluate the riskier project at 12 percent and the less- risky project at 10 percent. a. What is each project's expected annual cash flow? Project B's standard deviation ( \(\sigma_{\mathrm{B}}\) ) is \(\$ 5,798\) and its coefficient of variation \(\left(\mathrm{CV}_{\mathrm{B}}\right)\) is \(0.76 .\) What are the values of \(\sigma_{\mathrm{A}}\) and \(\mathrm{CV}_{\mathrm{A}} ?\) b. Based on their risk-adjusted NPVs, which project should BPC choose? c. If you knew that Project B's cash flows were negatively correlated with the firm's other cash flow, whereas Project A's flows were positively correlated, how might this affect the decision? If Project B's cash flows were negatively correlated with gross domestic product (GDP), while A's flows were positively correlated, would that influence your risk assessment?

Scenario analysis Your firm, Agrico Products, is considering a tractor that would have a net cost of \(\$ 36,000,\) would increase pre-tax operating cash flows before taking account of depreciation by \(\$ 12,000\) per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of \(\$ 7,200\) per year, beginning the first year. (Thus annual cash flows would be \(\$ 12,000,\) before taxes, plus the tax savings that result from \(\$ 7,200\) of depreciation.) The managers are having a heated debate about whether the tractor would actually last 5 years. The controller insists that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors actually do give 5 years of service. The service manager then states that some actually last for as long as 8 years. Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractor's life on the NPV. Use a 40 percent marginal federal-plusstate tax rate, a zero salvage value, and a WACC of 10 percent. Assuming each of the indicated lives has the same probability of occurring (probability \(=1 / 3\) ), what is the tractor's expected NPV? (Hint: Here straight-line depreciation is based on the MACRS class life of the tractor and is not affected by the actual life. Also, ignore the half-year convention for this problem.)

Required investment Truman Industries is considering an expansion. The necessary equipment would be purchased for \(\$ 9\) million, and it would also require an additional \(\$ 3\) million investment in working capital. The tax rate is 40 percent. a. What is the initial investment outlay? b. The company spent and expensed \(\$ 50,000\) on research related to the project last year. Would this change your answer? Explain. c. The company plans to use a building it owns but is not now using to house the project. The building could be sold for \(\$ 1\) million after taxes and real estate commissions. How would that affect your answer?

Depreciation methods Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires \(\$ 800,000\) of equipment. She is unsure what depreciation method to use in her analysis, straight-line or the 3 -year MACRS accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly over its 4 -year life (ignore the half-year convention for the straight-line method). The applicable MACRS depreciation rates are \(33,45,15,\) and 7 percent as discussed in Appendix 12A. The company's WACC is 10 percent, and its tax rate is 40 percent. a. What would the depreciation expense be each year under each method? b. Which depreciation method would produce the higher \(\mathrm{NPV}\), and how much higher would it be?
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