Chapter 8 - Pearson Learning Solutions

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$College of Marin Study Guide for Math 95 A,B - Pearson Learning ...$

342 PART THREE Long-Term Investment Decisionscases. The tax calculations apply whenever an asset is sold for a value differentfrom its book value. If the net proceeds from the sale are expected to exceed bookvalue, a tax payment shown as an outflow (deduction from sale proceeds) willoccur. When the net proceeds from the sale are less than book value, a tax rebateshown as a cash inflow (addition to sale proceeds) will result. For assets sold tonet exactly book value, no taxes will be due.Change in Net Working CapitalWhen we calculated the initial investment, we took into account any change innet working capital that is attributable to the new asset. Now, when we calculatethe terminal cash flow, the change in net working capital represents the reversionof any initial net working capital investment. Most often, this will show up as acash inflow due to the reduction in net working capital; with termination of theproject, the need for the increased net working capital investment is assumed toend. Because the net working capital investment is in no way consumed, theamount recovered at termination will equal the amount shown in the calculationof the initial investment. Tax considerations are not involved.Calculating the terminal cash flow involves the same procedures as thoseused to find the initial investment. In the following example, the terminal cashflow is calculated for a replacement decision.ExampleContinuing with the Powell Corporation example, assume that the firm expectsto be able to liquidate the new machine at the end of its 5-year usable life to net$50,000 after paying removal and cleanup costs. The old machine can be liquidatedat the end of the 5 years to net $10,000. The firm expects to recover its$17,000 net working capital investment upon termination of the project. Thefirm pays taxes at a rate of 40%.From the analysis of the operating cash inflows presented earlier, we can seethat the proposed (new) machine will have a book value of $20,000 (equal to theyear-6 depreciation) at the end of 5 years. The present (old) machine will be fullydepreciated and therefore have a book value of zero at the end of the 5 years.Because the sale price of $50,000 for the proposed (new) machine is below its initialinstalled cost of $400,000 but greater than its book value of $20,000, taxeswill have to be paid only on the recaptured depreciation of $30,000 ($50,000 saleproceeds $20,000 book value). Applying the ordinary tax rate of 40% to this$30,000 results in a tax of $12,000 (0.40$30,000) on the sale of the proposedmachine. Its after-tax sale proceeds would therefore equal $38,000 ($50,000 saleproceeds $12,000 taxes). Because the present machine would net $10,000 attermination, which is less than its original purchase price of $240,000 and aboveits book value of zero, it would experience a taxable gain of $10,000 ($10,000sale price$0 book value). Applying the 40% tax rate to the $10,000 gain, thefirm will have to pay a tax of $4,000 (0.40$10,000) on the sale of the presentmachine at the end of year 5. Its after-tax sale proceeds from the present machinewould therefore equal $6,000 ($10,000 sale price $4,000 taxes). Substitutingthe appropriate values into the format in Table 8.10 results in the terminal cashinflow of $49,000.2008935971Principles of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.
CHAPTER 8 Capital Budgeting Cash Flows 343After-tax proceeds from sale of proposed machineProceeds from sale of proposed machine $50,000 Tax on sale of proposed machine12,000Total after-tax proceeds—proposed $38,000 After-tax proceeds from sale of present machineProceeds from sale of present machine $10,000 Tax on sale of present machine4,000Total after-tax proceeds—present 6,000 Change in net working capitalTerminal cash flow17,000$49,000REVIEW QUESTION8–15 Explain how the terminal cash flow is calculated for replacement projects.LG4LG5ExampleLG6Hint Capital expendituresare critical to a firm’s success,and these funds are usuallylimited. Because of this, theprocess of determining cashflows should be finely tunedso that it is both objective andrealistic.8.6 Summarizing the RelevantCash FlowsThe initial investment, operating cash inflows, and terminal cash flow togetherrepresent a project’s relevant cash flows. These cash flows can be viewed as theincremental after-tax cash flows attributable to the proposed project. They represent,in a cash flow sense, how much better or worse off the firm will be if itchooses to implement the proposal.The relevant cash flows for Powell Corporation’s proposed replacement expenditurecan be shown graphically, on a time line. Note that because the new asset isassumed to be sold at the end of its 5-year usable life, the year-6 incrementaloperating cash inflow calculated in Table 8.9 has no relevance; the terminal cashflow effectively replaces this value in the analysis. As the following time lineshows, the relevant cash flows follow a conventional cash flow pattern.Time line for PowellCorporation’srelevant cash flowswith the proposedmachine0$26,480$57,680$55,600$61,200$ 49,000 Terminal Cash Flow73,200 Operating Cash Inflow$122,200 Total Cash Flow12345End of Year$221,1602008935971Techniques for analyzing conventional cash flow patterns to determinewhether to undertake a proposed capital investment are discussed in <strong>Chapter</strong> 9.Principles of Managerial Finance, Brief Fifth Edition, by Lawrence J. Gitman. Copyright © 2009 by Lawrence J. Gitman. Published by Prentice Hall.
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Chapter 8 - Pearson Learning Solutions

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