The paper "The Depreciation Tax Shield at Harriman Manufacturing Company" is a wonderful example of an assignment on finance and accounting. The net cash outlay which is the amount of capital investment required at the beginning of the project is $62,000. This encompasses the quoted price of the equipment and an additional $10,000 for installation cost (which includes transportation and equipment modification). Moreover, an additional $2000 is required for the working capital. The amount invested for working capital would be recovered at the termination of the project. Table 1 presents a tabular explanation of the above-given question. Table (1) Purchase of Machine 50,000 Add: Transportation and Equipment Modification 10,000 Installed Cost 60,000 Add: Initial increase in Inventory 3,000 Less: Increase in Accounts Payable 1,000 Total Initial Net Investment (outflow of cash) $62,000 b) As the question states, the project would save $20,000 in before tax labor operating costs each year therefore; the given amount is your earnings before tax for all three years.
Taxes would be deducted from EBT to arrive at the net operating income for the year. This amount will be added to the depreciation tax shield to get cash flow for the respective years.
The depreciation tax shield is a means to reduce taxable income for the company which is achieved through claiming the allowable deduction, which in this case is through depreciation. These deductions reduce the taxpayer’ s taxable income for the given year but add to operating cash flow. The depreciation tax shield is calculated as Table (2) gives depreciation expense and depreciation tax shield for the given year. The figures in the table (2) are used to find the net cash flow for the given year. The formula used to the calculate net cash flow is Table (2) Project Year IRS MACRS % Project's annual depreciation expense Remaining acct.
book value Depreciation Shield 0 60,000 1 33% $19,800.00 $40,200.00 $7,920.00 2 45% $18,090.00 $22,110.00 $7,236.00 3 15% $3,316.50 $18,793.50 $1,326.60 4 7% $18,793.50 $0.00 For the terminal year, the salvage value of the asset bought is added to the net cash flow. Table (3) presents a tabular explanation for all three years. Table (3) Year 1 Year 2 Year 3 EBT 20,000 20,000 20,000 Less: Tax (40%) 8,000 8,000 8,000 NI 12,000 12,000 12,000 Add: Depreciation Shield 7920 7236 1327 Add: Terminal Year Cash Flow 21518 Cash flow $19,920 $19,236 $34,845 c) Terminal year cash flow is calculated by adding the salvage value (which is the value of selling an asset to at t=3. The gain on the asset is calculated by: This is gain is taxable, therefore; the amount to be taxed will be deducted from the salvage value.
Lastly, the working capital investment which was made at the beginning of the project is recovered. The cash flow which is generated due to the termination of the project would be $21,518. Table (4) Salvage value 20000 Less: Tax on gain after selling the asset (482) Return on NWC 2000 Cash flow due to the termination of the project $21,518 d) For Harriman, all values are discounted at its weighted average cost of capital The cash flows are taken from Table (3) and inserted in the equation below. IRR: IRR= 8.48% Payback Period= The payback period represents the time by which the initial investment made by the company is recovered.
For Harriman, the payback period is 2 years and 8 months. This is calculated as: The investment should not be made as the project is giving negative NPV and an IRR which is below our cost of capital. The payback period is close to 3 years which makes the project unattractive for any investor.