Question

Consider an asset with the following cash flows:

	Year 0	Year 1	Year 2	Year 3
Cash flows ($ millions)	−72	31.20	28.80	26.40

The firm uses straight-line depreciation. Thus, for this project, it writes off $24 million per year in years 1, 2, and 3. The discount rate is 10%.

1. Complete the following table.
2. Does the economic depreciation equal the book depreciation?
3. Is the book rate of return the same in each year?
4. Is the project's book profitability its true profitability?

Complete the following table. (Leave no cells blank - be certain to enter "0" wherever required. Round your cash flow, economic income, economic rate of return, book income, and book rate of return answers to 2 decimal places. All other answers should be rounded to the nearest whole number. Input the rates of return as decimal values, not percents and other answers in millions not in dollars. Negative answers should be indicated with a minus sign.)

	Year 1	Year 2	Year 3
Cash Flow
PV at start of year
PV at and of year
Change in PV
Economic depreciation
Economic income
Economic rate of return
Book depreciation
Book income
Book rate of return

Answer 1

ANSWER:

	year1	year2	year3
cash flow	31.20	28.80	26.40
PV at the start of the year	72	48	24
PV at the end of the year	48	24	0
change in PV	-24	-24	-24
economic depreciation	24	24	24
economic income	7.20	4.80	2.40
economic rate of return	0.10	0.10	0.10
book depreciation	24	24	24
book income	7.20	4.80	2.4
book rate of return	0.10	0.10	0.10

For given project it writes off $24 million per year for 3 years and discount rate is 10%, the present value decrease s by $24 every year as it was written off. This is shown as depreciation in each year of $24 and the economic income is calculated as % on present value at start of year ( Discount rate). similarly book income is calculated.