Spear Company is considering a $5.4 million asset investment that has a four-year service life and a $400,000 salvage value. The investment is expected to produce annual savings in cash operating costs of $860,000 and will require a $250,000 overhaul in year 3, which is fully-deductible for tax purposes.Spear uses the net-present-value method to analyze investments. Asset investments are depreciated by the straight-line method, ignoring salvage values in related computations.Required:A. Ignoring income taxes, determine the (pre-discounted) cash-flow amounts that would be used in a net-present-value analysis for (1) the asset acquisition, (2) annual savings in cash operating costs, (3) annual straight-line depreciation, (4) the overhaul in year 3, and (5) disposal of the asset in year 4.

Question

Note cash outflows in parentheses.B. Repeat requirement "A," assuming the company is subject to a 30% income tax rate. Assume the company depreciates the asset using the optional straight-line method. Additionally, it depreciates it over the asset's service life (not its MACRS life).

What will be an ideal response?

Answer 1

A. Asset acquisition: $(5,400,000)
Annual savings in cash operating costs: $860,000
Annual straight-line depreciation: $0
Year 3 overhaul: $(250,000)
Year 4 asset disposal: $400,000
B. Asset acquisition: $(5,400,000)
Annual savings in cash operating costs: $860,000 × 0.7 = $602,000
Depreciation should be:
Year 1: $675,000 × .3 = $202,500
Year 2: $1,350,000 × .3 =$405,000
Year 3: $1,350,000 × .3 =$405,000
Year 4: $1,350,000 × .3 =$405,000
Year 5: $675,000 × .3 = $202,500
Year 3 overhaul: $(250,000) × 0.7 = $(175,000)
Year 4 asset disposal: $5,400,000 ? $5,400,000 accumulated depreciation = $0 book value; $0 book value - $400,000 salvage value = $400,000 gain; $400,000 gain × 0.3 = $(120,000) added tax; $400,000 salvage value ? $(120,000) added tax = $280,000