A company bought a piece of equipment for $200,000. It is being depreciated usin

Question

A company bought a piece of equipment for $200,000. It is being depreciated using MACRS with a three-year recovery period; you can use a look-up table to determine the depreciation amounts in years 1 through 4. The company has gross income of $100,000 per year, operating expenses of $50,000 per year, and a tax rate of 35%.

(a) Assume for now that the equipment will be discarded at the end of year 4. Make a table showing, for each of years 0 through 4: before-tax cash flow; the depreciation; the taxable income; the income tax; and the after-tax cash flow.

(b) What will be the company’s after-tax cash flow in year 4 if the equipment is sold for $25,000 at the end of year 4 (instead of being discarded)? Assume that depreciation recapture is taxed at the same rate as ordinary income.

Explanation / Answer

Calculation of depreciation on piece of equipment using MACRS with a three-year recovery period Year Cost of equipment Depreciation rate Depreciation 1 $200,000.00 33.33% $66,660.00 2 $200,000.00 44.45% $88,900.00 3 $200,000.00 14.81% $29,620.00 4 $200,000.00 7.41% $14,820.00 Answer a Table Year 0 1 2 3 4 Before Tax cash flow 0 $50,000.00 $50,000.00 $50,000.00 $50,000.00 Less : Depreciation 0 $66,660.00 $88,900.00 $29,620.00 $14,820.00 Taxable Income 0 -$16,660.00 -$38,900.00 $20,380.00 $35,180.00 Less : Tax @ 35% 0 -$5,831.00 -$13,615.00 $7,133.00 $12,313.00 Add : Depreciation 0 $66,660.00 $88,900.00 $29,620.00 $14,820.00 After tax Cash flow 0 $55,831.00 $63,615.00 $42,867.00 $37,687.00 Cost of equipment -$200,000.00 0 0 0 0 Net Cash flow -$200,000.00 $55,831.00 $63,615.00 $42,867.00 $37,687.00 Answer b Calculation of the company’s after-tax cash flow in year 4 Net Cash flow in Year 4 as per above Table $37,687.00 After tax salvage value of equipment $16,250.00 [Sale value *(1-tax rate)] = [$25000*(1-0.35)] Company’s after-tax cash flow in year 4 $53,937.00

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