Solutions to Cash Flow Practice Problems
- Identify each of the following items as either a positive cash
flow, negative cash flow, or no effect, and identify the dollar amount
(if a cash flow). Assume a marginal tax rate of 40%:
- Increase in Accounts Receivable by $5,000
- Negative cash flow of $5,000 (a use of funds)
- Increase in Inventory by $10,000
- Negative cash flow of $10,000 (a use of funds)
- Increase cash revenues by $100,000
- Positive cash flow
- $100,000 - 0.40($100,000) = $60,000
- Increase cash expenses by $60,000
- Negative cash flow
- -$60,000 + 0.40($60,000) = -$36,000
- Increase Accounts Paybable by $10,000
- Positive cash flow of $10,000 (funds that do not have to be paid
until some time in the future)
- Increase depreciation expense for
tax purposes by $30,000
- Positive cash flow
- $30,000 (0.40) = $12,000
- Suppose Congress changed the rates of depreciation for plant and
equipment assets such that a more accelerated system of rates is adopted.
How would you expect this change to affect the cash flows of a proposed
project that involves plant and equipment assets?
- Accelerating depreciation speeds up the benefits of depreciation
in terms of cash flows -- the depreciation tax-sheilds are realized
- Though this change does not affect the total depreciation
expense for tax purposes over the life of the asset, it does speed up
when the company can use these tax-shields, hence making the project more
valuable (that is, a higher net present value).
- Suppose that you are evaluating an asset that costs $400,000 and that is
depreciated for tax purposes using MACRS rates for a 5-year asset.
Assume a marginal tax rate of 30%.
- What is the depreciation expense in the second year?
- See page 78 of text for MACRS rates.
- Second year: depreciation expense = $400,000 x 32% = $128,000.
- What is the depreciation tax-shield in the second year?
- Depreciation tax-shield = $128,000 x 30% = $38,400.
- If you plan to dispose of the asset at the end of the third year,
what is the asset's book value for tax purposes at the time of sale?
- At the end of the 3rd year, you would have depreciated 20% + 32%
+ 19.2% = 71.2% or $284,800 of the asset's cost.
- The book value is $115,200.
- Another way to look at it: there is 11.52% + 11.52% + 5.76% = 28.8%
of the asset's cost remaining (28.8% of $400,000 = $284,400).
- If you can sell the asset for $50,000 at the end of the fifth year,
do you have a gain or a loss? What are the tax consequences of this
sale? What are the cash flow consequences?
- Book value at the end of the fifth year = 5.76% of $400,000 =
- Gain = $50,000 - 23,040 = $26,960.
- Tax consequences: tax = $26,960 x 30% = $8,088.
- Cash flow consequences = $50,000 - 8,088 = $41,912.