Charlotte Computer Services is considering purchasing equipment at $100 000. It
ID: 2394739 • Letter: C
Question
Charlotte Computer Services is considering purchasing equipment at $100 000. It is anticipated the equipment will have a useful life of five years. It will be depreciated on a straight-line basis. Operating revenue is expected to be $74 000 per annum and operating expenses $25 000 per annum. The equipment is subject to an investment allowance of 10 per cent and the tax rate is 30 per cent. The after-tax hurdle rate is 12 per cent.
a) The reduction in tax due to the investment allowance is?
b) What is the tax effect of the depreciation?
c) What is the Net Present Value of the investment?
Explanation / Answer
Solution a:
Total investment allowance = $100,000 * 10% = $10,000
Reduction in tax due to investment allowance = $10,000 *30% =$3,000
Solution b:
Annual depreciation = $100,000 / 5 = $20,000
Tax saving due to depreciation = $20,000 * 30% = $6,000
Therefore annual tax effect of the depreciation = $6,000
Solution c:
Computation of Annual cash flows Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Operating revenue $74,000.00 $74,000.00 $74,000.00 $74,000.00 $74,000.00 Operating expenses $25,000.00 $25,000.00 $25,000.00 $25,000.00 $25,000.00 Depreciation expense $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 Income before taxes $29,000.00 $29,000.00 $29,000.00 $29,000.00 $29,000.00 Income tax $8,700.00 $8,700.00 $8,700.00 $8,700.00 $8,700.00 Income after tax $20,300.00 $20,300.00 $20,300.00 $20,300.00 $20,300.00 Add: Depreciation $20,000.00 $20,000.00 $20,000.00 $20,000.00 $20,000.00 Add: Tax saving on investment allowance $3,000.00 Annual Cash inflows $43,300.00 $40,300.00 $40,300.00 $40,300.00 $40,300.00