10: Cash Flow and Capital BudgetingPrOBLEMS
TYPES OF CASH FLOWS
P10-1 Calculate the present value of depreciation tax savings on a depreciable asset with a purchase
price of $55 million and zero salvage value, assuming a 10% discount rate, a 30% tax rate, and
prime cost depreciation over the following periods:
a The asset is depreciated over a three-year life.
b The asset is depreciated over a seven-year life.
c The asset is depreciated over a 20-year life.
P10-2 A certain piece of equipment costs $32 million, plus an additional $2 million to install. This
equipment will be depreciated over five years using the diminishing value method. For a
company that discounts cash flows at 10% and faces a tax rate of 30%, what is the present value
of the depreciation tax savings associated with this equipment? By how much would that number
change if the company could treat the $2-million installation cost as a deductible expense rather
than include it as part of the depreciable cost of the asset?
P10-3 Taylor United is considering overhauling its equipment to meet increased demand for its
product. The cost of the equipment overhaul is $3.8 million, plus $200,000 in installation costs.
The company will depreciate the equipment modifications under the prime cost method using
a five-year recovery period. Additional sales revenue from the overhaul should amount to $2.2
million per year, and additional operating expenses and other costs (excluding depreciation) will
amount to 35% of the additional sales. The company has an ordinary tax rate of 30%. Answer the
following questions about Taylor United, for each of the next six years.
a What additional earnings, before depreciation and taxes, will result from the overhaul?
b What additional earnings after taxes will result from the overhaul?
c What incremental operating cash flows will result from the overhaul?
P10-4 Wilbur Corporation is considering replacing a machine. The replacement will cut operating
expenses by $24,000 per year for each of the five years that the new machine is expected to last.
Although the old machine has a zero book value, it has a remaining useful life of five years. The
depreciable value of the new machine is $72,000. Wilbur will depreciate the machine under the
prime cost method using a five-year recovery period, and is subject to a 30% tax rate on ordinary
income. Estimate the incremental operating cash flows attributable to the replacement.
P10-5 Advancedtronics Corporation is considering purchasing a new packaging machine to replace a
fully depreciated packaging machine that will last five more years. The new machine is expected
to have a five-year life and depreciation charges of $4,000 in year 1; $6,400 in year 2; $3,800
in year 3; $2,400 in both year 4 and year 5; and $1,000 in year 6. The company’s estimates of
revenues and expenses (excluding depreciation) for the new and the old packaging machines are
shown in the following table. Advancedtronics is subject to a 30% tax rate on ordinary income.
New packaging machine Old packaging machine
Year Revenue Expenses (excluding
depreciation)Revenue Expenses (excluding
depreciation)
1 $50,000 $40,000 $45,000 $35,000
2 51,000 40,000 45,000 35,000
3 52,000 40,000 45,000 35,000
4 53,000 40,000 45,000 35,000
5 54,000 40,000 45,000 35,000