[Anonymous]

I’m having trouble trouble understanding why there would be a 75,000 tax loss in this problem. The provided solution doesn’t provide an explanation. Am I missing something? Thanks for your help.

Kore Industries is analyzing a capital investment proposal for new equipment to produce a product over the next eight years. The analyst is attempting to determine the appropriate “end-of-life” cash flows for the analysis. At the end of eight years, the equipment must be removed from the plant and will have a net book value of zero, a tax basis of $75,000, a cost to remove of $40,000, and scrap salvage value of $10,000. Kore’s effective tax rate is 40%. What is the appropriate “end-of-life” cash flow related to these items that should be used in the analysis?

A.

$27,000

B.

$12,000

Incorrect C.

$(18,000)

D.

$(30,000)

Answer:

The key to solving this problem is separating the cash flow items from the noncash items. The $40,000 cost to remove the asset is a cash outflow. The scrap salvage value of $10,000 is a cash inflow. Both of these items are also part of the net income upon which tax must be computed. The $75,000 loss that will result from the disposal is also part of the net income upon which tax must be computed. However, the loss is not a cash outflow. What is a cash flow is the tax or tax savings in the net income or loss. The “end-of-life” cash flow may be calculated as follows:

Outflow: Cost to remove ($ 40,000)

Inflow: Salvage value $ 10,000

Inflow: Tax savings from

net loss $ 42,000 *

---

Net cash inflow $ 12,000

* The tax savings is calculated on a net loss of $105,000. The loss is a result of the $65,000 tax loss on the asset disposal ($75,000 tax basis offset by $10,000 scrap value) and the $40,000 cost to remove the asset.

Thanks for your help

[itsyoungmin]

Has anyone figured this problem out?
what are the revenue, expenses, depreciation in the equation for
cash flow: (revenue-cash expenses) X (1-Tax rate) + (Depreciation x Tax rate)?

Thanks

[Josh]

I'm having the same problem. I didn't know tax basis was treated as a loss.

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[Recked]

Tax basis of 75,000, but the only value when removed from service is 10,000.
When an asset is scrapped or deemed worthless its tax basis is written off to 0 for tax purposes, or to the value that it can be scrapped for.

Memento Mori - Kingston NY CPA & EA (SUNY Albany 2002)

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[TommyTheCat]

if i am understanding this correctly:

– we know for sure there are cash outflows of $40,000, and cash inflow of $10,000

Net cash outflow so far is $30,000.

We then know that the P&L looks like:

$65,000 loss on asset, plus another $40,000 expense for the disposal cost.

Net loss is $105,000.
At effective tax rate of $40,000, you'll have a tax savings of $42,000 for this deductible loss.

$30,000 outflow plus $42,000 cash “in flow” by way of savings in taxes equates to $12,000 net cash inflow from the sale. A net loss is a beneficial tax attribute in that it generates “cash flow” in the way of a cash refund, or a reduction in your other tax expense you might have if you were profitable and didnt have this loss generated on the sale/disposal.

Best way to think of it is assume you had income last year and paid tax at the corporate level. This year you have no other income other than what is laid out in this scenario. So you have a $105,000 NOL generated in the current year. You carry that NOL back to last year, a year in which you had an effective tax rate of 40%. Your carryback of the $105,000 loss generates a tax refund of $42,000.

So on a net basis, you spent $30,000 to dispose of the asset (cost of removal less salvage value), and you received a $42,000 refund on your prior year taxes from the carryback of the NOL. Badda bing $12k net positive cash flow.

Make sense?

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[TommyTheCat]

oops, i meant to say the following on line 7 of the above:

“At effective tax rate of $40,000 40%, you'll have a tax savings of $42,000 for this deductible loss.”

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[ryan.andrew6]

Tommy is correct. To elaborate, you have a basis of $75000 and sold the asset for $10000 leaving a loss of $65000. I think where some are getting thrown is the book value of $0 which has no effect on the tax return.

Although, after 8 years there should be no remaining tax basis on the equipment but they probably don't care!

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“You’re paying me five dollars an hour to find two cents—it doesn’t make sense”

[Author]

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