## Solutions to Cash Flow Practice Problems

1. 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

2. 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 earlier.
• 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).

3. 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 = \$23,040.
• 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.