Chapter 25, Problem 3BP

1.

To determine

Prepare a five-column table with the below that reports amount using the straight-line depreciation method for each of the six years:

1. a. Pretax income before depreciation,
2. b. Straight-line depreciation expense,
3. c. Taxable income,
4. d. Income taxes, and
5. e. Net cash flow.

Explanation of Solution

Cash flow:

Cash flow is the monetary consideration (return or income) received by the business for its long-term capital investment.

Straight-line depreciation method:

The depreciation method which assumes that the consumption of economic benefits of long-term asset could be distributed equally throughout the useful life of the asset, is referred to as straight-line method.

Prepare a five-column table that reports amounts using the straight-line depreciation for each of the six years as follows:

Years	(a)	(b)	(c)	(d)	(e)
	Income Before Depreciation	Straight-Line  Depreciation	Taxable Income	Income Taxes @ 40%	Net Cash Flows
			$\left(\text{a}-\text{b}\right)$	$\left(\text{c×40\%}\right)$	$\left(\text{a}-\text{d}\right)$
Year 1	$12,000	$3,000	$9,000	$3,600	$8,400
Year 2	12,000	6,000	6,000	2,400	9,600
Year 3	12,000	6,000	6,000	2,400	9,600
Year 4	12,000	6,000	6,000	2,400	9,600
Year 5	12,000	6,000	6,000	2,400	9,600
Year 6	$12,000	$3,000	$9,000	$3,600	$8,400

Table (1)

2.

To determine

Prepare a five-column table with the below that reports amount using the MACRS depreciation method for each of the six years:

1. a. Pretax income before depreciation,
2. b. MACRS depreciation expense,
3. c. Taxable income,
4. d. Income taxes, and
5. e. Net cash flow.

Explanation of Solution

Cash flow:

Cash flow is the monetary consideration (return or income) received by the business for its long-term capital investment.

Modified accelerated cost recovery system (MACRS):

This is a depreciation method permitted by Internal Revenue Service to be used for tax purposes because this method allows to record higher depreciation expense for certain years.

Prepare a five-column table that reports amounts using MACRS depreciation method for each of the six years as follows:

Years	(a)	(b)	(c)	(d)	(e)
	Income Before Depreciation	MACRS Depreciation	Taxable Income	Income Taxes @ 40%	Net Cash Flows
			$\left(\text{a}-\text{b}\right)$	$\left(\text{c×40\%}\right)$	$\left(\text{a}-\text{d}\right)$
Year 1	12,000	$6,000	$  6,000	$2,400	$  9,600
Year 2	12,000	9,600	2,400	960	11,040
Year 3	12,000	5,760	6,240	2,496	9,504
Year 4	12,000	3,456	8,544	3,418	8,582
Year 5	12,000	3,456	8,544	3,418	8,582
Year 6	12,000	1,728	10,272	4,109	7,891

Table (2)

3.

To determine

Compute the net present value of the investment under straight-line depreciation method, using 10% discount rate.

Explanation of Solution

Net present value method:

Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Compute the net present value of the investment under straight-line depreciation method, using 10% discount rate as follows:

Particulars	Cash flows Amount ($) (a)	PV Factor @ 10 % (b)	Present value $\left(\text{a}\times \text{b}\right)$
Net cash inflows:
Year 1	$  8,400	0.9091	$  7,636
Year 2	9,600	0.8264	7,933
Year 3	9,600	0.7513	7,212
Year 4	9,600	0.683	6,557
Year 5	9,600	0.6209	5,961
Year 6	8,400	0.5645	4,742
Total	$55,200		$40,041
Less: Amount invested			30,000
Net present value			$10,041

Table (3)

Note:

• For the present value factors refer Table B.1 in appendix-B.

4.

To determine

Compute the net present value of the investment under MACRS depreciation method, using 10% discount rate.

Explanation of Solution

Net present value method:

Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

Compute the net present value of the investment under MACRS depreciation method, using 10% discount rate as follows:

Particulars	Cash flows Amount ($) (a)	PV Factor @ 10 % (b)	Present value$\left(\text{a}\times \text{b}\right)$
Net cash inflows:
Year 1	$  9,600	0.9091	$  8,727
Year 2	11,040	0.8264	9,123
Year 3	9,504	0.7513	7,140
Year 4	8,582	0.6830	5,862
Year 5	8,582	0.6209	5,329
Year 6	7,891	0.5645	4,454
Total	$55,199		40,635
Less: Amount invested			30,000
Net present value			$10,635

Table (4)

Note:

• For the present value factors refer Table B.1 in appendix-B.

5.

To determine

Explain the reason for the increase in net present value under MACRS depreciation method.

Explanation of Solution

Explain the reason for the increase in net present value under MACRS depreciation method as follows:

From the above explanation it is clear that the net present value under MACRS depreciation method is higher than the net present value under straight-line depreciation method. This is due to the larger cash flows of the asset’s life in the earlier years. Hence, the depreciation deductions are also larger under MACRS depreciation method and thus this result in a less income tax payments in the earlier years.