Depreciation & Taxes

i
. Prime Consulting, Inc. operates consulting offices in Manila, Olongapo, and Cebu. The firm is presently
considering an investment in a new mainframe computer and communication software. The computer would
cost P6 million and have an expected life of 8 years. For tax purposes, the computer can be depreciated using
either straight-line method or Sum-of-the-Years’-Digits (SYD) method over five years. No salvage value is
recognized in computing depreciation expense and no salvage value is expected at the end of the life of the
equipment. The company’s cost of capital is 10 percent and its tax rate is 40 percent.
The present value of annuity of 1 for 5 periods is 3.791 and for 8 periods is 5.335. The present values of 1 end
of each period are:
1 0.9091 5 0.6209
2 0.8264 6 0.5645
3 0.6513 7 0.5132
4 0.6830 8 0.4665
The present value of the net advantage of using SYD method of depreciation with a five-year life instead of
straight-line method of depreciating the equipment is:
A. P 86,224 C. P215,560
B. P115,168 D. P287,893
ii
. For P450,000, Maleen Corporation purchased a new machine with an estimated useful life of five years with no
salvage value. The machine is expected to produce cash flow from operations, net of 40 percent income taxes,
as follows:
First year P160,000
Second year 140,000
Third year 180,000
Fourth year 120,000
Fifth year 100,000
Maleen will use the sum-of-the-years-digits’ method to depreciate the new machine as follows:
First year P150,000
Second year 120,000
Third year 90,000
Fourth year 60,000
Fifth year 30,000
The present value of 1 for 5 periods at 12 percent is 3.60478. The present values of 1 at 12 percent at end of
each period are:
End of:
Period 1 0.89280
Period 2 0.79719
Period 3 0.71178
Period 4 0.63552
Period 5 0.56743
Had Maleen used straight-line method of depreciation instead of declining method, what is the difference in net
present value provided by the machine at a discount rate of 12 percent?
A. Increase of P 9,750 C. Decrease of P24,376
B. Decrease of P 9,750 D. Increase of P24,376

Accounting rate of return

Based on initial investment
iii
. A piece of labor saving equipment that Marubeni Electronics Company could use to reduce costs in one of its
plants in Angeles City has just come onto the market. Relevant data relating to the equipment follow:
Purchase cost of the equipment P432,000
Annual cost savings that will be provided by the equipment 90,000
 Life of the equipment 12 years
What is the simple rate of return to be provided by the equipment?
A. Between 15% and 18%. C. 20.83%.
B. 25.00%. D. 12.50%.

Based on average investment

iv
. The BIBO Company has made an investment in video and recording equipment that costs P106,700. The
equipment is expected to generate cash inflows of P20,000 per year. How many years will the equipment have
to be used to provide the company with a 10 percent average accounting rate of return on its investment?
A. 7.28 years C. 9.05 years
B. 5.55 years D. 4.75 years
v
. Show Company is negotiating to purchase an equipment that would cost P200,000, with the expectation that
P40,000 per year could be saved in after-tax cash operating costs if the equipment were acquired. The
equipment’s estimated useful life is 10 years, with no salvage value, and would be depreciated by the straight-
line method. Show Company’s minimum desired rate of return is 12 percent. The present value of an annuity of
1 at 12 percent for 10 periods is 5.65. The present value of 1 due in 10 periods, at 12 percent, is 0.322.
The average accrual accounting rate of return (ARR) during the first year of asset’s use is:
A. 20.0 percent C. 10.0 percent
B. 10.5 percent D. 40.0 percent
vi
. An asset was purchased for P66,000. The asset is expected to last for 6 years and will have a salvage value of
P16,000. The company expects the income before tax to be P7,200 and the tax rate applicable to the company
is 30%. What is the average return on investment (accounting rate of return)?
A. 17.6% C. 10.9%
B. 7.6% D. 12.3%

Net Investment
vii
. The Makabayan Company is planning to purchase a new machine which it will depreciate, for book purposes, on
a straight-line basis over a ten-year period with no salvage value and a full year’s depreciation taken in the year
of acquisition. The new machine is expected to produce cash flows from operations, net of income taxes, of
P66,000 a year in each of the next ten years. The accounting (book value) rate of return on the initial investment
is expected to be 12 percent. How much will the new machine cost?
A. P300,000 C. P550,000
B. P660,000 D. P792,000
viii
. The Fields Company is planning to purchase a new machine which it will depreciate, for book purposes, on a
straight-line basis over a ten-year period with no salvage value and a full year’s depreciation taken in the year of
acquisition. The new machine is expected to produce cash flow from operations, net of income taxes, of
P66,000 a year in each of the next ten years. The accounting (book value) rate of return on the initial investment
is expected to be 12%. How much will the new machine cost?
A. P300,000 C. P660,000
B. P550,000 D. P792,000

CFAT
ix
. The Hills Company, a calendar company, purchased a new machine for P280,000 on January 1. Depreciation
for tax purposes will be P35,000 annually for eight years. The accounting (book value) rate of return (ARR) is
expected to be 15% on the initial increase in required investment. On the assumption of a uniform cash inflow,
this investment is expected to provide annual cash flow from operations, net of income taxes, of
A. P35,000 C. P42,000
B. P40,250 D. P77,000
Payback Period
x
. If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of its ten-year life, and
generates annual net cash inflows of P5,000 each year, the cash payback period is
A. 8 years C. 6 years
B. 7 years D. 5 years
xi
. Consider a project that requires cash outflow of P50,000 with a life of eight years and a salvage value of P5,000.
Annual before-tax cash inflow amounts to P10,000 assuming a tax rate of 30% and a required rate of return of
8%. Salvage value is ignored in computing depreciation. The project has a payback period of
A. 5.0 years C. 6.0 years
B. 5.6 years D. 6.6 years
xii
. The following incomplete information is provided for an investment decision.
Discount Discounted Cumulative Cash
Year Cash Flow Factor (10%) Cash Flows Flows
0 P(450,000) 1.000 P(450,000) P(450,000)
1 280,000 .909 254,520
2 210,000 .826
3 140,000 .751
Using break-even time (BET) analysis, when will the investment be recovered?
A. In 2.73 years C. At the end of year 2
B. Longer than three years D. In 2.21 years
xiii
. Orlando Corporation is considering an investment in a new cheese-cutting machine to replace its existing
cheese cutter. Information on the existing machine and the replacement machine follow:
Cost of the new machine P400,000
Net annual savings in operating costs 90,000
Salvage value now of the old machine 60,000
Salvage value of the old machine in 8 years 0
Salvage value of the new machine in 8 years 50,000
Estimated life of the new machine 8 years
What is the expected payback period for the new machine?
A. 4.44 years C. 2.67 years
B. 8.50 years D. 3.78 years
xiv
. For P4,500,000, Siniloan Corporation purchased a new machine with an estimated useful life of five years with
no salvage value at its retirement. The machine is expected to produce cash flow from operations, net of income
taxes, as follows:
First year P 900,000
Second year 1,200,000
Third year 1,500,000
Fourth year 900,000
Fifth year 800,000
Siniloan will use the sum-of-the-years-digits’ method to depreciate the new machine as follows:
First year P1,500,000
Second year 1,200,000
Third year 900,000
Fourth year 600,000
Fifth year 300,000
 What is the payback period for the machine?
A. 3 years C. 5 years
B. 4 years D. 2 years
xv
. Paz Insurance Company’s management is considering an advertising program that would require an initial
expenditure of P165,500 and bring in additional sales over the next five years. The cost of advertising is
immediately recognized as expense. The projected additional sales revenue in Year 1 is P75,000, with
associated expenses of P25,000. The additional sales revenue and expenses from the advertising program are
projected to increase by 10 percent each year. Paz Insurance Company’s tax rate is 40 percent.
The payback period for the advertising program is
A. 4.6 years C. 3.0 years
i
10.Answer: B
Year SYD Straight Line Difference Present Value
1 2,000,000 1,200,000 800,000 727,280
2 1,600,000 1,200,000 400,000 330,560
3 1,200,000 1,200,000 - 0
4 800,000 1,200,000 (400,000) (273,200)
5 400,000 1,200,000 (800,000) (496,720)
Total present value of difference in depreciation 287,920
Tax Rate 40%
Present value of net advantage 115,168

ii
.Answer: B
SYD SL Difference Present Value
1 150,000 90,000 60,000 53,568
2 120,000 90,000 30,000 23,916
3 90,000 90,000 - 0
4 60,000 90,000 (30,000) (19,066)
5 30,000 90,000 (60,000) (34,046)
Total of present values of depreciation 24,372
Tax rate 40%
Present value of net advantage 9,749
SYD method provides a higher present value on tax benefits because of less amount of tax during year 1 & 2. In year 4
and 5, the use of SYD requires higher taxes but their equivalent present values are lower already.

iii
.Answer: D
Annual cost savings 90,000
Less depreciation (432,000 ÷ 12) 36,000
Annual income 54,000
Simple Rate of Return: 54,000 ÷ 432,000 12.5 %

iv
.Answer: A
The useful life of the project can be calculated by using the computational pattern for Accounting Rate of Return:
Net investment 106,700
Divide by Depreciation expense
CFAT 20,000
Less: Net income (106,700 x 5%) 14,665 5,335
Average life (in years) 7.28
* 10% ARR based on average investment = 5% ARR based on initial investment

v
.Answer: B
ARR = Average annual net income ÷ Average Investment
Annual after-tax cash flow 40,000
Less Depreciation 20,000
Net Income 20,000
Divide by Average Investment (200,000 + 180,000)/2 190,000
ARR: 10.5%
The problem asked for the average accounting rate of return for the first year of asset’s life.

vi
.Answer: D
The average (accounting) rate of return is determined by dividing the annual after-tax net income by the average cost of
the investment, (beginning book value + ending book value)/2.
 After tax income (P7,200 - (P7,200 x 30%)) P 5,040
Average investment: (P66,000 + 16,000) ÷ 2 P41,000
Accounting rate of return: P5,040/P41,000) 12.3%

vii
.Answer: A
(ATCF – Depreciation) ÷ Initial investment = Accounting Rate of Return
Let X = Initial investment
(66,000 – 0.10X) ÷ X = 0.12
66,000 - .10X = .12X
.22X = 66,000
X = 300,000

viii
.Answer: A
Net Income: = 66,000 - .10X
AAR = NI/ Investment
.12 = (66,000 - .10X) / X
.12X = 66,000 - .10X
.22 X = 66,000
X = 300,000

ix
.Answer: D
Net Income (280,000 x 15%) 42,000
Add back depreciation 35,000
ATCF 77,000

x
.Answer: B
Payback period = Initial amount of investment ÷ Annual after-tax cash flows
P35,000 ÷ P5,000 = 7 years

xi
.Answer: B
Net investment 50,000
Divide by CFAT (10,000 x 0.7) ÷ (50,000 ÷ 8 x 0.3) 8,875
Payback period 5.6 years

xii
.Answer: D
Cumulative cash flows end of Year 1 (450,000) – 254,520 (195,480)
Discounted cash flow for Year 2 173,460
Cumulative cash flows, end of Year 2 ( 22,020)
Break-even time 2 + (22,020 ÷ 105,140) 2.21 years

xiii
.Answer: D
Cost of the new machine 400,000
Salvage value of old machine at period zero 60,000
Net investment (Outflows) 340,000
Divide by cash flow after tax 90,000
Payback period 3.78 years

xiv
.Answer: B
Cash Inflow Unrecovered Outflow
Outflows (4,500,000)
First year 900,000 (3,600,000)
Second year 1,200,000 (2,400,000)
 Payback Period: At the end of 4 periods, the initial outflows are fully recovered.
Note to the CPA Candidates: A modified question for this problem is to compute the Present Value of the net advantage
of using sum-of-the-years’ digits of depreciation instead of straight-line method.

xv
.Answer: C
Cash inflows Investment
Period 0 (99,300)
Period 1 (75,000 – 25,000) x .6 30,000 (69,300)
Period 2 ( 30,000 x 1.10) 33,000 (36,300)
Period 3 (33,000 x 1.10) 36,300 -0-
At the end of the third year, investment is fully recovered.
The net investment of 99,300 is net of tax benefit, (165,500 x .6)