Acct 2220 Zeigler: Linton Tire Co (E10-8A Solution - Pg 325)

First, always prepare a timeline of all cash inflows and outflows.

Whenever income taxes are involved, we must prepare an income stmt to determine the tax impact. Prepare an Inc Stmt (Handout #4) to determine the periodic (annual) cash flows. In this case, the equipment investment (at time 0 = today) of $360,000 is compared to annual revenues ($400k), less annual expenses of $210k. Thus, the investment should provide a $190,000 NET benefit per year. In addition, depreciation must be addressed as it represents a tax deduction (i.e. tax shield / tax shelter) that will lower the tax liability associated with these new (190k/yr) benefits expected.

Note 1: Since a benefit (enhancement to earnings) from the investment is expected each year, taxes will be due on the benefit received after depreciation is considered.

Note 2: Depreciation is a tax deduction (i.e. ‘cost recovery’ of the investment) and does shield income against taxation. As such, we deduct depreciation in the determination of taxable income, but we then add it back to determine the after-tax cash flow being generated from the investment each period:

Revenues / $400,000
Operating expenses / (210,000)
“Net Benefit” per year / $190,000 / Pre-tax (subject to tax)
Depr Exp (non-cash) / (90,000) / ($360,000 – $0) ¸ 4 = $90k
Income before taxes / 100,000
Tax expense (cash) / (30,000) / ($100,000 x 0.30)
Net income (effect of the investment on Fin Stmts) / 70,000 / Note: This is also used for the Unadjusted Rate of Return calculation (see P10-22A)
Add back depreciation / 90,000
Net annual cash inflows for investment / $160,000 / (After-tax)

Note that the difference between pre and post-tax cash inflows is only due to the taxes paid ($30,000). This is the entire (only) reason to construct the above income stmt when taxes are part of the analysis. No inc stmt is ever required for a pre-tax analysis because depreciation is a non-cash item. Depr *is* relevant for a post-tax analysis because a deduction is allowed in determining the tax liability.

The next step is to apply typical net present value (NPV) analysis on all periodic (annual in this case) cash flows, assuming a particular “discount”, ”hurdle”, or ”required” rate of return.

Comments: Using a 20% discount rate required by mgmt (as added in class), we found the investment would produce a positive NPV. Further, the exact rate of return (“IRR”) was approximately 27.76% using our Excel IRR calculator (Handout #3 & Key Formula #2). Last, using Key Formula #3 in class, the “minimum annual net benefit” would be $139,064 to achieve a 20% return. I recommend confirming your understanding of all three Key Formulas used and discussed (and the IRR Excel file posted). See me, or our GA team, with any questions.