Salvage Value while calculating Depreciation in Capital Budgeting

CFA Level II Corporate Finance
#1

Hi All,

Regarding the treatment of Salvage Value in Cash Flow Projections, do we have to consider the salvage value while determining the Depreciable amount?

For example,

Cost of asset = 5000

Salvage value=2000

Useful life = 5

tax rate = 40%

What will be depreciation charge to be used in Cash Flow projections?

  1. Depreciation tax shield = (5000-2000)/5= 600 per year

At the end of project tax, suppose we realize 2000 by selling the asset.

Tax on gain = (2000- (5000-3000))*40%= 0

OR

  1. Depreciation tax shield = 5000/5= 1000 per year

At the end of project tax, suppose we realize 2000 by selling the asset.

Tax on gain = (2000- 0)*40%= 800

While studying for CMA, it is emphasized that salvage value has to ignored while calculating depreciable amount & full cost has to be charged as depreciation whether using straight line or reducing method as required by tax laws.

While practicing questions, I noticed that in some cases, CFA text ignores Salvage value for determining depreciable amount & in some cases they consider.

What is the appropriate treatment of salvage value??

Any help will be highly appreciated.

#2

Point 2 is correct. Typically, the asset is assumed to have a book value or “accounting salvage value” of 0 at the end of it’s useful life, which we use to calculate depreciation.

There is also sale price, market value, or “expected savage value”, which is treated as a gain or loss. This is determined by the difference between the sale price and book value at the time of sale. While a gain is taxed, a loss earns a tax credit.

It’s also important to note that the depreciation tax shield, as well as other cash flows require adjustments when examining replacement projects as we are concerned with the incremental cash flows.

I think it’s best to use these assumptions lightly and only in regard to the capital budgeting section.