I feel like I’m missing something basic here. Anyway, for the EOCs in reading 25, to calculate depreciation expense, you just take the fixed capital investment divided by the useful life. The questions usually have you depreciate the asset to zero, so I get that. But also, the questions say that the asset will be sold for some value at the end of its life. That future selling price is used as salvage value for TNOCF, but why is salvage value not accounted for when calcualting depreciation expense?
For example in Problem 1:
Depreciation = 460,000/5 = 92,000
TNOCF = 85,000 + 73,000 - .4(85,000) = 124,000
Why would you not subtract 85,000 from 460,000 before dviding by 5 years?
You’ll depreciate the asset on a straight line basis to nil; therefore each depreciation charge in your example is $92k.
However, when you come to sell the asset, the fair value (market value) is infact $85 and your book value is Nil. Therefore you need to add the gain on the sale after tax to your terminal cash flow.
Think about it this way; for whatever reason be it for tax savings or just incorrectly depreciating the asset, they will receive a cash inflow at the time they go to sell, the asset isn’t valued at Nil.
Think about it this way. Depreciation expense used for accounting and allows the company to save money by paying less taxes year after year. If you depreciate the asset to 0, you’ve basically exhausted all the tax savings on the asset. If, however, you sell the asset for the 85,000 (like in the problem), it means that the asset is actually not worth 0 and you must pay taxes on that amount - $85,000.
Oh, makes sense, I think I’m getting it now. So the company chooses to underestimate salvage value (to zero) in order to have higher depreciation expenses so it can reduce it’s taxes, thus increasing yearly operating cash flows and likewise, increasing NPV. However, because the company depreciatied the asset too much, it now has a gain that it has to pay taxes on in the future. So it’s basically meant to defer taxes now and pay them later on the sale.
It sounds like something that the government would try to prevent because you’re effectively getting an interest free loan from them.