Asked by Alejandro Arias on Jun 01, 2024
Verified
Mesko Corporation has provided the following information concerning a capital budgeting project: The company's income tax rate is 30% and its after-tax discount rate is 15%. The company uses straight-line depreciation on all equipment. Assume cash flows occur at the end of the year except for the initial investments. The company takes income taxes into account in its capital budgeting.The total cash flow net of income taxes in year 2 is:
A) $42,000
B) $56,000
C) $62,000
D) $80,000
After-Tax Discount Rate
The discount rate used in investment or project valuation that accounts for the effects of taxes on the project's cash flows.
Straight-Line Depreciation
A method of allocating an asset's cost evenly over its useful life.
Initial Investments
The initial amount of money invested in a project, asset, or company to start operations or purchase assets.
- Calculate and interpret the total cash flow net of income taxes for different years of a project’s life.
Verified Answer
Operating cash flow in year 2 = EBIT - taxes + depreciation
= $375,000 - ($375,000 * 0.30) + $230,000
= $332,500
Tax cash flow in year 2 = taxes paid in year 2 - tax savings from depreciation in year 2
= ($375,000 * 0.30) - ($230,000 * 0.30)
= $22,500
Total cash flow net of income taxes in year 2 = operating cash flow + tax cash flow
= $332,500 + $22,500
= $355,000
However, we need to adjust this amount for the salvage value in year 5, since that will also impact the cash flow in year 2. The salvage value is calculated as:
Salvage value in year 5 = $900,000 - ($900,000 * 0.30)
= $630,000
The book value of the equipment at the end of year 2 is equal to its initial cost minus two years of depreciation:
Book value at end of year 2 = $2,500,000 - ($2,500,000 / 5 * 2)
= $1,000,000
Since the book value is less than the salvage value, the equipment is sold in year 2 and the salvage value is included in the cash flow:
Total cash flow net of income taxes in year 2 = operating cash flow + tax cash flow + salvage value
= $332,500 + $22,500 + $630,000
= $985,000
The correct answer is (C) $62,000.
Learning Objectives
- Calculate and interpret the total cash flow net of income taxes for different years of a project’s life.
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