[I'm, Ron Burgundy?]

When determining the depreciation tax shield for an NPV calculation do you include the increase in working capital in the depreciation base for the tax shield? I have come across multiple questions in Becker and Wiley, and even got into a back and forth email conversation with one of Becker’s support CPA’s on this topic but they were unable to clarify to my satisfaction.

Please take a look at the question below. It is my understanding that any initial outlay would be included in the calculation i.e. increases in working capital, shipping, installation, etc. However, some answers contradict this principal. I realize that if working capital is to be released at the end of the asset’s life it is to be treated in the calculation in the same manner as salvage value i.e. discounting the amount back to the present value (PV of $1). This should not have any affect on the depreciation base.

Can someone please clarify this for me once and for all? I’m attaching a Wiley question from the Wiley Test Bank as an example. As you see here, they are not including the increase in working capital as part of the depreciation tax shield used to come up with the after tax cash flow. It was my understanding that this would be included. Perhaps I’m reading the question wrong. Please let me know…

Question:

Assume that management of Trayco has generated the following data about an investment project that has a five-year life:

Initial investment $100,000

Additional investment in working capital 5,000

Cash flows before income taxes for years 1 through 5 30,000

Yearly depreciation for tax purposes 20,000

Terminal value of machine 0

Cost of capital 8%

Present value of $1 received after 5 years discounted at 8% .681

Present value of an ordinary annuity of $1 for 5 years at 8% 3.993

Assume that Trayco’s marginal tax rate is 30% and all cash flows come at the end of the year. What is the amount of the after-tax cash flow in year 2?

$27,000

$25,000

$30,000

$21,000

Answer Explanation:

$27,000

The after-tax cash flows are calculated by taking the before-tax cash flows and deducting the income taxes. Since depreciation is deductible for tax purposes, income taxes for year two are $3,000 [($30,000 cash flows – $20,000 depreciation) × 30%]. Therefore, after-tax cash flows are equal to $27,000 ($30,000 cash flows before taxes – $3,000 taxes).

"If you're going through hell, keep going"
- Winston Churchill

"I've missed over 9,000 shots in my career. I've lost over 300 games. 26 times I've been trusted to take the game winning shot, and missed. I've failed, over and over and over again in my life. And that is why, I succeed."
- Michael Jordan

BEC: (54), (72), 80 (losing credit on 02/02/15 - nervous)
AUD: 78
REG: (74), 91
FAR: (71)

[jlg2010]

Jared, the initial outlay and recovery of WC is relevant in determining CFs, but not tax shield purposes. Why? There generally will be no tax implications…is it assumed that the cash received recovering any WV investment (e.g. liquidating inventories) will equal book value (tax basis).

FAR Aug 12 84
Aud Feb 13 99
BEC Apr 13 86
Reg May 13 87 Done!!!

[jlg2010]

Jared, the initial outlay and recovery of WC is relevant in determining CFs, but not tax shield purposes. Why? There generally will be no tax implications…is it assumed that the cash received recovering any WV investment (e.g. liquidating inventories) will equal book value (tax basis).

FAR Aug 12 84
Aud Feb 13 99
BEC Apr 13 86
Reg May 13 87 Done!!!

[Shanta_J]

The question is asking for cash flow in YEAR 2 … your initial outlays, etc takes place in YEAR 1

$30,000 * .70 = $21,000

$20,000 * .30 = $6,000

You take your annual cash flows which is $30k before take and multiple it by 1-Tax rate to get your after tax of $21K

Then you take your depreciate since it is it for tax purposes and multiple it by the tax rate.

Add them together and you have your $27K

REG*75* 02.27.13(1)
AUD*82* 04.15.13(1)
BEC 05.29.13
FAR 08.12.13

-Becker Self-Study-
*Through God all things are Possible*

[Shanta_J]

The question is asking for cash flow in YEAR 2 … your initial outlays, etc takes place in YEAR 1

$30,000 * .70 = $21,000

$20,000 * .30 = $6,000

You take your annual cash flows which is $30k before take and multiple it by 1-Tax rate to get your after tax of $21K

Then you take your depreciate since it is it for tax purposes and multiple it by the tax rate.

Add them together and you have your $27K

REG*75* 02.27.13(1)
AUD*82* 04.15.13(1)
BEC 05.29.13
FAR 08.12.13

-Becker Self-Study-
*Through God all things are Possible*

[I'm, Ron Burgundy?]

Thank you both for your help. I understand how to do the calculation. However, what I'm stuck on is the figure of the depreciation itself. Why would you not include the $5000 increase in WC into the equation and have the equation look like this:

$30,000 * .70 = $21,000

$25,000 * .30 = $7,500

= $28,500

It was my understanding that the initial outlay of WC would be included in the depreciation tax shield but that is not the case in this instance and I cannot figure out why that is.

Please let me know your thoughts.

"If you're going through hell, keep going"
- Winston Churchill

"I've missed over 9,000 shots in my career. I've lost over 300 games. 26 times I've been trusted to take the game winning shot, and missed. I've failed, over and over and over again in my life. And that is why, I succeed."
- Michael Jordan

BEC: (54), (72), 80 (losing credit on 02/02/15 - nervous)
AUD: 78
REG: (74), 91
FAR: (71)

[I'm, Ron Burgundy?]

Thank you both for your help. I understand how to do the calculation. However, what I'm stuck on is the figure of the depreciation itself. Why would you not include the $5000 increase in WC into the equation and have the equation look like this:

$30,000 * .70 = $21,000

$25,000 * .30 = $7,500

= $28,500

It was my understanding that the initial outlay of WC would be included in the depreciation tax shield but that is not the case in this instance and I cannot figure out why that is.

Please let me know your thoughts.

"If you're going through hell, keep going"
- Winston Churchill

"I've missed over 9,000 shots in my career. I've lost over 300 games. 26 times I've been trusted to take the game winning shot, and missed. I've failed, over and over and over again in my life. And that is why, I succeed."
- Michael Jordan

BEC: (54), (72), 80 (losing credit on 02/02/15 - nervous)
AUD: 78
REG: (74), 91
FAR: (71)

[smalltimeauditor]

You're over-complicating this. Simplify: Think Revenue (CASH FLOW) – Expense (DEPRECIATION) = Taxable Income Base and then multiply this base by your Income Tax %.

Cash flows are given to you – use it. Working capital is not used in any calculation to figure your depreciation tax shield.

($30,000 – $20,000) x 30% = $3,000

$30,000 – $3,000 = $27,000

B - Passed
A - Passed
R - Passed
F - Passed

[smalltimeauditor]

You're over-complicating this. Simplify: Think Revenue (CASH FLOW) – Expense (DEPRECIATION) = Taxable Income Base and then multiply this base by your Income Tax %.

Cash flows are given to you – use it. Working capital is not used in any calculation to figure your depreciation tax shield.

($30,000 – $20,000) x 30% = $3,000

$30,000 – $3,000 = $27,000

B - Passed
A - Passed
R - Passed
F - Passed

[Anonymous]

I am having difficulty coming up with the same answer as the Wily Practice test for the same problem only…Calculate the net present value of the project is the desired answer.

A.) $ 6,216

B.) $ 11,216

C.) $105,000

D.) $ 3,585

I am a bit looney as I have been at this since 5:30 yesterday afternoon as it is part of an assignment that was due last night. I fail to see how $6,216 is the npv. If someone has a minute, would you please slap me with a brick so that it gets in there somehow? Many thanks

[Anonymous]

I am having difficulty coming up with the same answer as the Wily Practice test for the same problem only…Calculate the net present value of the project is the desired answer.

A.) $ 6,216

B.) $ 11,216

C.) $105,000

D.) $ 3,585

I am a bit looney as I have been at this since 5:30 yesterday afternoon as it is part of an assignment that was due last night. I fail to see how $6,216 is the npv. If someone has a minute, would you please slap me with a brick so that it gets in there somehow? Many thanks

[SoFlaAuditor]

REG - 83
BEC - 81
AUD - 73, 92
FAR - 90

Done!

[SoFlaAuditor]

REG - 83
BEC - 81
AUD - 73, 92
FAR - 90

Done!

[NoraU]

Initial Investment 100,000 + 5,000 additional investment in working capital (assumed to be recovered after 5 years) = 105,000.

PV of 27,000 yearly cash flow for 5 years 27,000*3.993=107,811.

PV of 5,000 after 5 years 5,000*0.681=3,405

Answer: 107,811+3,405-105,000=6,216.

BEC 05/12/14 77
REG 08/25/14 82
FAR 11/25/14 80
AUD 02/25/15 72, 05/15/15 98! DONE!!!!!!!!!!!!!!!!!!!!!!

[NoraU]

Initial Investment 100,000 + 5,000 additional investment in working capital (assumed to be recovered after 5 years) = 105,000.

PV of 27,000 yearly cash flow for 5 years 27,000*3.993=107,811.

PV of 5,000 after 5 years 5,000*0.681=3,405

Answer: 107,811+3,405-105,000=6,216.

BEC 05/12/14 77
REG 08/25/14 82
FAR 11/25/14 80
AUD 02/25/15 72, 05/15/15 98! DONE!!!!!!!!!!!!!!!!!!!!!!

[Author]

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