INITIAL INVESTMENTrefers to the relevant cash outflows considered when evaluating a prospective capital expenditure.

These are:• the installed cost of new asset• After Tax proceeds from sale of Old Asset• Change in next working capital

THE INSTALLED COST OF NEW ASSET

Installed Cost of New Asset- is the Cost of New Asset plus installation cost (if any)

• CNA= net outflow its acquisition requires• IC = any added costs necessary to

place an asset for operations

Example: Installed Cost of New AssetTable 11.1 The Cost of new Asset is the Net Outflow that its acquisition requires

Installation Costs are any added cost necessary to place an asset into Operation

Example: Cost of New Asset = $40,000 Installation Cost = 10,000 Then the Basic Initial Investment =$ 50,000 or the Depreciable Value

After Tax Proceeds from Sale of Old Asset

ATPSOA= is the difference between the old asset’s sale proceeds and any applicable taxes or tax refunds related to its sale

• Book Value=difference between installed cost and accumulated depreciation

• Basic Tax Rule =3 possible taxes: more than its BV’ for its BV; Less than its BV.

RECAPTURED DEPRECIATION• The portion of an asset’s sale price that is

above its book value and below its initial purchase price

• Example: if Hudson sells the old asset for $110,000 the gain is $62,000 or:

= $110,000 - $48,000 = $62,000Where: Recaptured Depreciation is $ 52,000

or and initial gain is $100,000 (IP)-$48,000(BV)

AFTER TAX PROCEEDS FROM SALE OF OLD ASSET

The after Tax proceeds from sale of old asset decrease the firm’s initial investment in the new asset.

These proceeds are the difference between the old asset’s sale proceeds and any applicable taxes or tax refunds related to sale.

The proceeds from sale of old asset are subject to type of tax

This Tax on sale of old asset depends on the relationship between its sale price and Book Value and on existing government tax rules

Tax Treatment on Sale of AssetsFORM OF tax

DEFINITION TAX TREATMENT

ASSUMED TAX RATW

GAIN PORTION OF SALE PRICE MORE THAN ITS BV

TAXED AS ORDINARY

INCOME

40%

LOSS ON SALE OF ASSET

AMOUNT IS LESS THAN ITS BOOK VALUE

If Depreciable and used in business, loss is DEDUCTEDIf not depreciable or not used in Business, loss is deductible only against CAPITAL GAINS.

40% OF LOSS IS Tax Savings

40% OF LOSS IS Tax Savings

STEP1. COMPUTE BOOK VALUE

The Book Value of an Asset is its strict accounting value.

Formula: Book Value= Installed Cost of Asset Less: Accumulated DepreciationCalculate: BV = $50,000 - $39,000 = $11,000Where: AD at the end of 2 years at 33% & 45%Is .33+.45 X $50,000 i= $39,000

EQUIVALENCIES ON % ACCUMULATED DEPRECIATION FOR RECOVERY YEARSRecovery Year 3 Years 5 Years 7 Years 10 Years

1 33% 20% 14% 10%2 45 32 25 183 15 19 18 144 7 12 12 125 12 9 96 5 9 87 9 78 4 69 6

10 611 4

In Page 169 these % are used in computing the Accumulated Depreciation

11.2 Hudson IndustriesUsing the 5 year recovery period the asset was being

depreciated in year 1 and 2 as follows: Book Value= $100,000 - $52,000 = $48,000Where:Cost of Recovery for year 1 & 2 is $52,000 computed

as follows: = .20+ .32 X $100,000 = .52 X $100,000 = $52,000

Discussion

Discussion

Illustration on Recovery period at the end of 4 years Book Value= $100,000 - $83,000

= $17,000Where: Cost of Recovery for year 1, 2, 3, & 4 = .20+.32+.19+.12 X $100,000 = .83 X $100,000 = $83,000

Discussion11.3 If Hudson Industries decides to sell the asset

which was purchased 2 years ago and its current Book Value is $48,000More than its Book Value = $110,000 - $48,000Total Gain Above Book Value = $62,000Where: Initial Purchase Price = $100,000- $48,000 Recaptured Depreciation = $52,000 (20%+32%) Both Recaptured Depreciation and Capital Gain Tax are Added Capital Gain is $10,000 + $52,000 = $62,000

Discussion

11.3 If Hudson Industries decides to sell the asset which was purchased 2 years ago and its current Book Value is $48,000

At its Present Book Value = $100,000 - $48,000No Gain No Loss = $62,000Where: Recaptured Depreciation = $100,000- $48,000 Recaptured Depreciation = $52,000 Computed as .20+.32 X $100,000 = $ 52,000

Discussion

11.3 If Hudson Industries decides to sell the asset for its Book Value or the Asset is sold at $48,000

NO GAIN OR LOSSBecause no Tax results from selling an Asset for

its Book ValueThere is no Tax Effect on the Initial Investment in

the New Asset

Discussion

11.3 If Hudson Industries decides to sell the asset for

less than its Book Value say for example $30,000THERE IS LOSS OF $18,000 = $48,000- $30,000 = $18,000 (Loss)

11.5 Powell CorporationUsing the 5 year recovery period the asset was being

depreciated in year 1,2 & 3 as follows:Book Value= $100,000 - $52,000 = $48,000Where:Cost of Recovery for year 1 & 2 = .20+ .32 X $100,000 = .52 X $100,000 = $52,000

Discussion

EXERCISES ON ACCUMULATED DEPRECIATION 11-2 pp 502

Recovery Year 10 Years Initial Investment Cost of Recovery Book Value1 10% $120,000 $12,000 108,000

2 18 $115,000 20,700 98,4003 14 $110,000 15,400 103,2004 12 $105,000 12,600 105,6005 9 $100,000 9,000 109,2006 8 $95,000 7,600 24,0007 7 $90,000 6,300 111,6008 6 $85,000 5,100 112,8009 6 $80,000 4,800 112,800

10 6 $75,000 4,500 112,80011 4 $70,000 2,800 115,200

$65,000 2,600 64,400$60,000 2,400 57,600$55,000 2,200 52,800

11.7 Find the Book Value (Answer B,C,D,E)

Asset Installed Cost Recovery Period Elapsed time Since Purchased

A 980,000 5 3B 40,000 3 2

C 96,000 5 4

D 400,000 5 1

E 1,500,000 10 5

A 980,000 5 320% .7132 = $980,000X .7119 = $695,800

= $980,000-$695,800 = $284,200

11.10 Change in Net Working CapitalCurrent Asset Current

LiabilitiesAccount Change

$920,000 $640,000 Accruals +45,000Machine Securities 0

Inventories -25,000Accounts Payable +75,000

Notes Payable 0Accounted Receivable +155,000

Cash +35,000 Present $ 920,000- 640,000 = $280,000Expected Change Net Working Capital = $155,000 + 35,000 + 75,000 + 45,000 = $310,000- 25,000 = $285,0002. Why change is relevant in determining initial Investment for proposed replacement action3. Would change in NWC enter into any of the other cash flow components that make up the relevant cash flows?

11.11 Calculating Initial Investment Vastine Medical, Inc.Cost of Asset

Computer

Present Value of

Comp System

Depreciation under MACRS 5 YR RECOVERY

Cost of New Comp System

Elapsed time Since Purchased

$375,000 20% $500,000 .52 X 375,000

200,000 32 = $195,000

1912125

Book Value $ 375,000- 195,000 = $180,000Gain Realized=200,000 – 180,000 = $20,000New System = $500,000 X .40 = $200,000After Tax = $500,000- 200,000 = $ 300,000

11.12 Calculating Initial Investment Basic Calculation Cushing Corporation.

Cost of Old

Machine

Present Value

Depreciation under MACRS 5 YR RECOVERY

Cost of New Machine + Installation

Cost

Elapsed time Since Purchased

$20,000 $28,000 20% $40,000 .71 X 20,00032 5,000 = $14,200

19 $45,00012 Tax40%= $18,000125

Book Value $ 20,000- 14,200 = $5,800Gain Realized=28,000 – 5,800 = $22,200New System = $45,000 X .40 = $18,000After Tax = $45,000-18,000 = $ 27,000

11.13 Initial Investment at Various Prices

Old Machine

Present Value

Depreciation under MACRS 5 YR RECOVERY

Cost of New Machine + Installation

Cost

Computed 5 yr

$10,000 $11,000 20% $24,000 .95 X 26,000

7,000 32 2,000 = $24,700

2,900 19 $26,000

1,500 12 Tax40%= $10,400125

Book Value $ 26,000- 24,700 = $1,300 a) Gain Realized = $11,000 – $10,000Gain Realized=28,000 – 5,800 = 1,000 = $22,200 b) = $7,000 – $10,000New System = $26,000 X .40 = ($3,000) = $10,400 c) = $ 2,900- 10,000After Tax = $26,000-10,400 = ($7,100) = $ 15,600 d) = ($8,500)

11.11 Calculating Initial InvestmentCurrent Asset Current

LiabilitiesAccount Change

920,000 640,000 Accruals +45,000Machine Securities 0

Inventories -25,000Accounts Payable +75,000

Notes Payable 0Accounted Receivable +155,000

Cash +35,000 Present $ 920,000- 640,000 = $280,000Expected Change in Initial Investment= $155,000 + 35,000 + 75,000 + 45,000 = $310,000- 25,000 = $285,000

Conclusions/ Generalization/Evaluation

• In finding the Book Value of an Asset, it needs the use of MARCS depreciation for applicable percentages on recovery periods and its elapsed time since its purchase. Deduct first the elapsed % before performing another ordinary tax deductions

Conclusions/ Generalization/Evaluation

• Calculating the change in Net Working Capital of a new machine to replace the old one is to use comparative Income and Expenses Summary as follows in Ex.11.6

year New Revenue Expenses year Old Revenue Expenses1 $2,520,000 $2,300,000 1 $2,200,000 $1,990,0002 $2,520,000 $2,300,000 2 $2,300,000 $2,110,0003 $2,520,000 $2,300,000 3 $2,400,000 $2,230,0004 $2,520,000 $2,300,000 4 $2,400,000 $2,250,0005 $2,520,000 $2,300,000 5 $2,250,000 $2,120,000

New Proposed Machine• Purchase Price= $380,000• Installation price= 20,000• Total Cost $400,000• 1st year = $400,000 X .20= $80,000• 2nd year= $400,000 X .32= $128,000• 3rd year= $400,000 X .19= $ 76,000• 4th year= $400,000 X .12= $ 48,000• 5th year= $400,000 X .12= $ 48,000• 6th year= $400,000 X .05= $ 20,000• $400,000

With Present Machine (old)

• 1st year = $240,000 X .12= $28,000• 2nd year= $240,000 X .12= $28,000• 3rd year= $240,000 X .05= $12,000• =$69,600

Operating Cash InflowsRevenue Less : Expenses (Excluding Depreciation and Interest)

Earnings before Depreciation, Interests and TaxesLess: Depreciation

Earnings Before Interest and TaxesLess: Taxes (rate=T)

Net Operating Profit after Taxes[NOPAT=EBIT X(1 – T)Add: Depreciation

Operating Cash Inflows (same as OCF in n Equation 4.3) pp 170

(Assignment)

• Check on the following exercises in your book- pages 502-514

• Compute the following and pass them next meeting: P11-12, P11-13, P11-16, P11-19

• Be ready for Quiz