Question

Calculate the total terminal cash flow using both straight line depreciation and then using MACRS depreciation. The asset has an installed cost of $500,000, a five-year life and a 3-year MACRS. The tax rate is 20%. The asset can be sold at the end of year 5 for $100,000. It requires an increase in NWC at time 0 in the amount of $40,000. Explain why they are the same or different.

Answer 1

Under straight line depreciation, the annual depreciation = 500000/5 = 100000

When the asset is sold at the end of Year 5, the book value of the equiment is reduced to zero

Terminal cash flow = Salvage value - Tax paid on salvage value + Recovery of NWC

= 100000 - (100000-0)*20% + 40000

= 100000 - 20000 + 40000

= 120000

Under the MACRS depreciation at the end of Year 4, the asset would be depreciated fully.

Since the book value is zero, the terminal cash flow will be equal to the one calculated under the straight line depreciation.

Under both the straight line depreciation and MACRS the terminal cash flow is equal to $120000

The terminal cash flow is same for both the methods because the book value of the asset is reduced to zero at the time of sale of asset.