308 CHAPTER 8 Cash Flow Estimation and Risk Analysis
Part 3 estimates the cash flows the firm will realize when it disposes of the as-
sets. Row 57 shows the salvage value, which is the sales price the company expects
to receive when it sells the assets four years hence. Row 58 shows the book values
at the end of Year 4; these values were calculated in Part 2. Row 59 shows the ex-
pected gain or loss, defined as the difference between the sale price and the book
value. As explained in notes c and d to Table 8-3, gains and losses are treated as or-
dinary income, not capital gains or losses.^5 Therefore, gains result in tax liabilities,
and losses produce tax credits, that are equal to the gain or loss times the 40 per-
cent tax rate. Taxes paid and tax credits are shown on Row 60. Row 61 shows the
after-tax cash flow the company expects when it disposes of the asset, found as theTABLE 8-3 Analysis of a New (Expansion) Project
Parts 1 and 2(^5) Note again that if an asset is sold for exactly its book value, there will be no gain or loss, hence no tax lia-
bility or credit. However, if an asset is sold for other than its book value, a gain or loss will be created. For
example, RIC’s building will have a book value of $10,908, but the company only expects to realize $7,500
when it is sold. This would result in a loss of $3,408. This indicates that the building should have been de-
preciated at a faster rate—only if depreciation had been $3,408 larger would the book and market values
have been equal. So, the Tax Code stipulates that losses on the sale of operating assets can be used to reduce
ordinary income, just as depreciation reduces income. On the other hand, if an asset is sold for more than
its book value, as is the case for the equipment, then this signifies that the depreciation rates were too high,
so the gain is called “depreciation recapture” by the IRS and is taxed as ordinary income.