Identifying and Calculating the Relevant Cash Flows CMA Part 2

Depreciation Tax Shield – A Cash Inflow

The most difficult recurring cash flow over the life of the asset is the cash flow that arises from the
depreciation tax shield. As we have already discussed in respect to the tax effect of the initial investment in
the assets, the tax effect of the asset is received as the asset is depreciated. We will now look at this
depreciation tax shield in more detail.

The amount of depreciation that will be deductible for tax purposes will depend upon the depreciation method
being used for tax purposes. For most assets, the method of tax depreciation in the U.S. is calculated using
a system called MACRS (Modified Accelerated Costs Recovery System), and it is essentially based on the
double declining balance method of depreciation (or the 200% declining balance method – these are two
names for the same thing). However, a problem could say that any method of depreciation is being
used for tax purposes.

If MACRS being used, the annual depreciation amount is calculated as the cost of the asset multiplied by the
MACRS depreciation rate for each year the depreciation is taken. The depreciation rate is a different rate for
each year, and of course depends on the number of years over which a property is depreciated. These rates
will be given to you in the exam problem, but it is important that you remember to multiply this rate by the
full cost of the asset. Salvage (or residual) value is not taken into account when calculating the
depreciation for the depreciation tax shield in capital budgeting regardless of which depreciation
method is being used.

Regardless of what method of depreciation is being used for tax purposes, the depreciable base
for tax purposes is always 100% of the asset’s cost, according to U.S. tax regulations. This is true
even if the depreciation method for tax purposes is the straight-line method and not MACRS.

This amount of tax-deductible depreciation will be a reduction of the company’s taxable income, because
depreciation expense is a tax-deductible expense. The amount of tax-deductible depreciation will cause an
equal reduction in the company’s taxable income. That will, in turn, cause a reduction in the amount of tax
that will be due. This tax reduction will not represent an actual cash inflow, but it reduces the cash outflow of
the company for taxes. Therefore, the amount of tax savings that occurs as a result of the depreciation
expense is treated as a cash inflow for capital budgeting purposes. The amount of tax savings that results is
called the depreciation tax shield.

The depreciation tax shield is calculated as follows for each year of an asset’s life:

Annual Depreciation as Calculated × Marginal tax rate

If the new machine is replacing an old machine that still is usable and is not yet fully depreciated, the only
relevant depreciation amount to use here is the amount of change in each year’s depreciation expense
between the new machine and the machine it will replace. Note that this amount of change in the annual
depreciation expense may be different in different years of the project, since the depreciation on the old
machine (if kept) might have ended before the useful life of the new machine ends. This is discussed in more
detail later, and an example is presented.

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Note: On the exam, you will be told the method of depreciation that is being used for tax purposes. Make
sure you read the problem carefully to identify the method, and calculate the depreciation and the
depreciation tax shield using whatever method is given. If the problem gives one depreciation method for
book purposes and another method for tax purposes, always use the method being used for tax
purposes.

Note that for tax purposes, the entire cost of an asset is always depreciated over its depreciable
life. That means do not subtract any salvage value from the cost to calculate the depreciable
base, regardless of what method of depreciation is being used.

If straight-line depreciation is used for tax purposes, do not subtract the salvage value from the cost to
calculate the depreciable base, even though straight-line depreciation for book purposes does require the
subtraction of the salvage value. Under U.S. tax laws, 100% of an asset’s cost is always depreciated on
the tax return, and so that is what the exam requires for depreciation calculations for capital budgeting.

If you are using some of the older former CMA questions in your studies (other than those in your HOCK
program), you may find that the rule of not subtracting salvage value from the cost is not being followed in
some of those problems. At one time, the exam required depreciation to be calculated differently, and
those old questions reflect that. Do not be concerned about this. It does not mean that you should
calculate the depreciation that way now. The correct way to calculate depreciation has changed since those
questions were released, and the ICMA will not expect problems to be solved that way on exams today.
Unfortunately, some old questions are still being distributed according to the former standards, and that
has confused quite a few candidates. You should calculate the depreciation on those questions the correct
way. If your answer differs from the “correct” answer given, determine whether the difference is due to the
fact that they subtracted the salvage value from the cost in calculating the depreciable base. If that is the
only difference, then you have solved the problem correctly.

All questions in your HOCK study materials have been updated to use the currently correct depreciation
calculations.

Cash Flows at the Disposal or Completion of the Project

When the project is terminated, there are number of potential cash flows related to this event. These
potential cash flows are:

1) Cash received from the disposal of equipment. The cash that is received from the sale of any
assets (equipment, machines or the investment project itself) is a cash inflow in the final year of the
project.

Tax Effect: If the sale of the assets results in a gain or loss, there will be a tax effect from this
gain or loss. The gain or loss is calculated by comparing the tax basis (or book value, if the tax
basis is not given) with the cash received. If there is a gain, the cash inflow will be reduced by the
taxes paid on the gain. If there is a loss, the loss will be tax deductible and this tax savings will
be added to the cash received from the sale to calculate the cash inflow. This tax treatment is the
same as the treatment of the gain or loss on the sale of the old equipment at the start of the
project.

As with the sale of old equipment, in the event of a loss, we must assume that the company has
other capital gains that it can deduct the loss from and thus will be able to use the loss to lower
its tax bill.

Again, as with the sale of the old equipment, it is possible that a problem will tell you that the
company’s tax rate for capital gains is different from its tax rate for cash flows from operations. If
that occurs, use the tax rate for capital gains to calculate the tax due on the gain.

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2) Recovery of working capital. The initial incremental investment and any subsequent investments
in working capital are usually fully recouped at the end of the project. This is because the final ac-
counts receivable will be collected and not replaced with other accounts receivable (for this project),
the inventory associated with the project will have been sold, and all the related accounts payable
paid. It is also possible for an investment in working capital to be recovered before the end of the
project. Whenever working capital is recovered, it is a cash inflow in that year with no tax effect.

Tax Effect: There is no tax effect related to working capital. Therefore, the amount that needs to
be included in the capital budgeting analysis is the actual amount of the working capital that is
recovered at the end of the project.

Note: It is very common on the exam for a question to look only at the cash flows in the final year of the
project. You need to remember that there are usually two events in this type of question: 1) the sale of
the assets themselves, and 2) the release of working capital. Of these, there is a tax effect only for the
gain or loss on the sale of the asset. The release of working capital is not a taxable event.

In addition, there may be after-tax operating cash flows and/or a depreciation tax shield for the final year.
Whether to use these or not in the answer depends on what the question asks for and what information is
given. For instance, if the equipment will be fully depreciated before the final year, there will be no
depreciation tax shield in the final year. And even though there may be cash flow from operations and
depreciation in the final year, the question may ask only for the cash flows related to the disposition of the
equipment, for example.

Question 49: Garfield, Inc. is considering a 10-year capital investment project with forecasted revenues of
$40,000 per year and forecasted cash operating expenses of $29,000 per year. The initial cost of the
equipment for the project is $23,000, and Garfield expects to sell the equipment for $9,000 at the end of
the 10th year. The equipment depreciates over 7 years. The project requires a working capital investment
of $7,000 at its inception and another $5,000 at the end of year 5. Assuming a 40% marginal tax rate,
the expected net cash flow from the project in the 10th year is:

a) $32,000

b) $24,000

c) $20,000

d) $11,000

(CMA Adapted)

Question 50: Kore Industries is analyzing a capital investment proposal for new equipment to produce a
product over the next 8 years. The analyst is attempting to determine the appropriate "end-of-life" cash
flows for the analysis. At the end of 8 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) $45,000

b) $27,000

c) $12,000

d) $(18,000)

(CMA Adapted)

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Depreciation for Tax Purposes

The tax basis of an asset is the asset’s book value for tax purposes. In the U.S., many companies use a
different method of calculating depreciation on their tax return than they use for book purposes. This is
because the tax laws say that depreciation must be calculated a certain way on the tax return, whereas U.S.
GAAP says it must be calculated a different way for financial reporting. In capital budgeting, we need to find
what effect the depreciation reported on the tax return will have on cash. Even though depreciation itself is a
non-cash expense, it has an effect on the amount of tax that is due, because the depreciation expense
reduces net taxable income. The amount of tax due is based on net taxable income, and taxes paid affect
cash. Therefore, we must use the type of depreciation that will be used on the tax return to calculate the
depreciation tax shield in the capital budgeting analysis. Furthermore, when the asset is sold, we use the
asset’s tax basis – its book value for tax purposes – to calculate the amount of gain or loss from the sale of
the asset.

MACRS is the most common type of depreciation that the U.S. tax laws require, although it is not the only
acceptable method a company can use on its tax return. We already mentioned that the depreciable base
for tax purposes, regardless of what method of depreciation is being used for tax purposes, is
always 100% of the cost of the asset and the other costs required to make it ready for use. Any
anticipated salvage value at the end of the asset’s life is never subtracted from the original cost when
calculating depreciation for tax purposes.

When MACRS (Modified Accelerated Costs Recovery System) is being used for tax purposes, we have another
consideration to be aware of. The U.S. tax laws require that a portion of a year’s depreciation be taken in the
year the asset is acquired and a portion of a year’s depreciation be taken in the year the asset is disposed of.
The most common portion is ½ year’s depreciation in both the first and the last year, regardless of the actual
date the asset was purchased. This is called the half-year convention. We still depreciate a 3-year asset
over a 3-year period. However, that 3-year period begins in the middle of the year in which the asset is
acquired (assumed to be June 30), and it ends in the middle of the year in which the asset is disposed of. So,
for example, a three-year asset purchased in Year 1 will be depreciated as follows:

Year 1 ½ of one year’s depreciation

Year 2 1 year’s depreciation

Year 3 1 year’s depreciation

Year 4 ½ of one year’s depreciation

This works out to three full years of depreciation, but the depreciation is taken over a period of four tax years.

The U.S. Internal Revenue Service provides MACRS tables for use in calculating the amount of depreciation to
take each year. The tables give the percentage of the original cost to be depreciated each year, and they
incorporate the half-year convention, so the percentages are not adjusted for the half year at the
beginning and the half year at the end.

As an example, for an asset that is being depreciated over 3 years using MACRS and the half-year
convention, here are the percentages given in the tables. You do not need to learn these percentages for
the exam. If you will be required to use MACRS on the exam, the percentages will be given in the question.
These are offered only so you can be familiar with what you could see.

Year 1 33.33%

Year 2 44.45%

Year 3 14.81%

Year 4 7.41%

Total 100.0%

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So if an asset’s original cost is $90,000 and it is considered 3-year property for tax purposes and is being
depreciated using MACRS and the half-year convention, the amount of depreciation to be taken for each year
will be as follows:

Year 1 33.33% $29,997

Year 2 44.45% 40,005
Year 3 14.81% 13,329
Year 4 7.41% 6,669
Total 100.0% $90,000

The method of calculating straight-line depreciation for tax purposes generally requires that assets be
depreciated on a monthly basis. However, for purposes of the exam, this is not a problem. If a question tells
you to use straight-line depreciation for tax purposes, it will usually tell you that the asset was purchased on
either January 1 or on June 30/July 1.

x If the asset was purchased on January 1, take a full year of depreciation in the year acquired. For
example, a 3-year asset will be depreciated over only 3 tax years, not 4 tax years.

x If the asset was purchased on June 30 or July 1, take ½ year of the annual straight-line depreciation
amount in the year acquired and leave ½ year of depreciation for the final year. A 3-year asset will
be depreciated over 4 tax years.

And remember that if straight-line depreciation is used for tax purposes, do not the subtract the salvage
value to calculate the depreciable base. The depreciable base is 100% of the asset’s cost.

Other Tax Considerations

When management of a company is making an investment decision, it needs to take into account the effect
that the investment will have on its state and local taxes. We have already covered the tax effect of income
taxes. However, there may be other tax considerations that should be considered as well.

The company’s management will need to consider available tax concessions or reliefs when it is comparing
different options for investment. A tax concession or relief is a reduction in the tax rate that the company
needs to pay (concession) or perhaps a period of time during which taxes do not need to be paid at all
(relief). This can become a very complicated issue when a company has investments in different countries or
tax jurisdictions in the U.S.

For example, it is common for a city, state or county to grant property or other tax concessions to a company
in order to persuade the company to build an office or production facility within that region. These
concessions can only be for taxes that that government levies (such as local income taxes or property taxes).
This means that local governments cannot provide federal tax concessions or relief.

We are not going to focus on the numbers related to the above tax issues (different tax jurisdictions or tax
concessions), but you simply need to be aware that these considerations do exist.

We will look only at the effect of income taxes on the cash flows that a company will have in relation to a
particular project.

Irrelevant Cash Flows

When determining relevant cash flows, remember that sunk costs, such as the book value of existing
equipment, are not relevant, because they will not change as a result of any capital budgeting project under
consideration. Also, there may be overhead costs allocated to a branch, for instance, and the capital
budgeting project under consideration would cause an increase in the overhead costs to be allocated to that
branch. However, that is also not relevant unless the total overhead costs for the company as a whole will
actually change as a result of the project. If the total overhead costs do not change but are simply allocated

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differently as a result of the project and this branch gets more, then other branches will get less. As long as
the total overhead costs incurred will not change as a result of the project, there is no relevant increase in
costs.

Financing cash flows are also irrelevant. Cash flows associated with financing of the project – principal and
interest payments on debt or dividends on stock issued – are not a part of any capital budgeting analysis.
The cost of the financing is captured in the discount rate, or hurdle rate, that is used for discounted cash flow
methods. (This will be explained later.) Including the cash flows for financing in the analysis would be double
counting them. If financing can ultimately be obtained on a more favorable basis than anticipated, this can
add value to the actual project. But the financing cash flows are never included in the capital budgeting
analysis that is used to make a decision about whether or not to embark upon a capital budgeting project.

Example of Calculation of After-Tax Relevant Cash Flows

CMA Products, Inc. is considering the purchase of a new piece of equipment to introduce a new product line.
The equipment will cost $125,000, including setup costs, installation and testing. The estimated before-tax
annual cash flow from operations is $50,000, and the investment will require an initial investment in working
capital of $25,000. The estimated salvage value is $10,000. CMA has an effective income tax rate of 30%.

The equipment will have an economic life of 9 years, but will be depreciated for tax purposes over 7 years
f
using MACRS. The MACRS depreciation rates for each of the years (using the half-year convention ) are as
follows:

Year 1 .1429
Year 2 .2449
Year 3 .1749
Year 4 .1249
Year 5 .0893
Year 6 .0892
Year 7 .0893
Year 8 .0446

The relevant after-tax cash flows are:

Net Initial Investment:

Initial investment in equipment $(125,000) cash outflow

Initial investment in working capital ( 25,000) cash outflow

Disposal of old equipment 0.00

Net Initial Investment $(150,000)

After-tax cash flow from operations (excluding depreciation effect):

$50,000 before-tax CF × (1 - .30) = $35,000 $ 35,000 net cash inflow/yr.

f
Note that because MACRS depreciation and the half-year convention are being used, depreciation for a 7-year asset is
being taken during years 1 through 8. This is another example of the MACRS percentages supplied by the Internal Revenue
Service being used to calculate the depreciation to be taken each year.

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Depreciation Tax Shield (30% of depreciation; varies by year due to different MACRS depreciation rates):

Year 1 $125,000 × .1429 × .30 = $5,359

Year 2 $125,000 × .2449 × .30 = $9,184
Year 3 $125,000 × .1749 × .30 = $6,559
Year 4 $125,000 × .1249 × .30 = $4,684
Year 5 $125,000 × .0893 × .30 = $3,349
Year 6 $125,000 × .0892 × .30 = $3,345
Year 7 $125,000 × .0893 × .30 = $3,349
Year 8 $125,000 × .0446 × .30 = $1,671
Year 9 0

After-tax cash flow from disposal at salvage value:

$10,000 - $0 tax basis = $10,000 gain

$10,000 × (1 - .30) = after-tax CF, Year 9 $7,000

Therefore, the relevant, after-tax cash flows per year are:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9

Initial
Investment (125,000)
in Equipment

Working
Capital ( 25,000) 25,000*
Increase

After-Tax CF
from 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000
Operations

Depr Tax
5,359 9,184 6,559 4,684 3,349 3,345 3,349 1,671 -0-
Shield

After-Tax CF
from 7,000
disposal

Total After
Tax Cash (150,000) 40,359 44,184 41,559 39,684 38,349 38,345 38,349 36,671 67,000
Flows

* Recovery of released working capital.

Note: Any increase in working capital that occurs in the first year (or any other year during the project)
will be a reduction of the cash inflows for that period. In this example, the increase in working capital came
in Year 0. However, increases in working capital could occur in other years, as well. Note that the working
capital is released in the final year of the project and becomes a cash inflow at that time.

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