Question

The characteristics of the proposed purchase plan of a new piece of equipment are as following:

Initial capital cost = HK$ 5000

Useful life = 5 years

Salvage value = 0

Expected annual income = 6000 - 100 j (j = 1, 2, 3, 4, 5 years)

Expected annual disbursements = 950 + 50 j

Effective tax rate = 20%

(1)Tabulate the cash flows after tax if the effective tax rate is 20% and the straight line depreciation method is used.

(2)If the "Double-Declining-Balance Method" and the "Sum-of-Years'-Digits Method" are used for the calculation of the depreciation, please tabulate the cash flows before tax, the annual depreciation, the annual tax, and the cash flows after tax. And compare the accumulated depreciations in the end of the 5th year between these two methods.

(3)Please investigate and comment that how the "effective tax rate" and its variation will affect the results of the above questions. For example, the "effective tax rate" varies +/- 0~0.05 based on the original 0.20 (i.e. the effective tax rate varies in the range between 15%~25%).

Answer 1

Year--St'line depn	0	1	2	3	4	5
1.Initial capital cost	-5000
2.Expected annual income		6000	5900	5800	5700	5600
3.Expected annual disburs.		-950	-1000	-1050	-1100	-1150
4.St.line dpen.		-1000	-1000	-1000	-1000	-1000
5.EBIT(2+3+4)		4050	3900	3750	3600	3450
6. Tax at 20%		-810	-780	-750	-720	-690
7. NOPAT(5+6)		3240	3120	3000	2880	2760
8.Add back:depn.		1000	1000	1000	1000	1000
9.Operating cash flow		4240	4120	4000	3880	3760

DDB method of depn.
Year	0	1	2	3	4	5
1.Initial capital cost	-5000
2.Expected annual income		6000	5900	5800	5700	5600
3.Expected annual disburs.		-950	-1000	-1050	-1100	-1150
4.DDB dpen.		-2000	-1200	-720	-432	-259
5.EBIT(2+3+4)		3050	3700	4030	4168	4191
6. Tax at 20%		-610	-740	-806	-833.6	-838.2
7. NOPAT(5+6)		2440	2960	3224	3334.4	3352.8
8.Add back:depn.		2000	1200	720	432	259
9.Operating cash flow		4440	4160	3944	3766	3612

Sum of the Years digits method of depn.
Year	0	1	2	3	4	5
1.Initial capital cost	-5000
2.Expected annual income		6000	5900	5800	5700	5600
3.Expected annual disburs.		-950	-1000	-1050	-1100	-1150
4.SOYD dpen.		-1667	-1333	-1000	-667	-333
5.EBIT(2+3+4)		3383	3567	3750	3933	4117
6. Tax at 20%		-676.6	-713.4	-750	-786.6	-823.4
7. NOPAT(5+6)		2706.4	2853.6	3000	3146.4	3293.6
8.Add back:depn.		1667	1333	1000	667	333
9.Operating cash flow		4373	4187	4000	3813	3627

DDB rate = St.line rate *2= 1/5*2= 40% on declining balance					Depn. Base digits= 1+2+3+4+5=15
Year	BV*40%	Acc. Depn.	BV		Year	Depreciation		Acc. Depn.	BV
0			5000		0				5000
1	2000	2000	3000		1	5/15*5000=		1666.67	3333.33
2	1200	3200	1800		2	4/15*5000=		3000.00	2000.00
3	720	3920	1080		3	3/15*5000=		4000.00	1000.00
4	432	4352	648		4	2/15*5000=		4666.67	333.33
5	259	4611	389		5	1/15*5000=		5000	0.00
	Acc. Depn.=	4611					Acc. Depn.=	5000

Effect of tax 15% & 25%

cash flow decreases with increase in Tax rate (25%)& increases when tax rate decrease.(15%)

tax at 20%
OCF-St.line		4240	4120	4000	3880	3760
OCF-DDB		4440	4160	3944	3766.4	3611.8
OCF-SOYD		4373	4187	4000	3813	3627
Tax a t15%
OCF-St.line		4443	4315	4188	4060	3933
OCF-DDB		4593	4345	4146	3975	3821
OCF-SOYD		4543	4365	4188	4010	3832
Tax at 25%		4038	3925	3813	3700	3588
OCF-St.line		4288	3975	3743	3558	3402
OCF-DDB		4204	4008	3813	3617	3421
OCF-SOYD