Answer (B) is correct . The estimated incremental after-tax operating cash flows for each year of a capital project consist of two components:? the after-tax cash inflows from operations and the depreciation tax shield arising from the purchase of new equipment (note that salvage value is not subtracted when calculating the depreciation tax shield). The first of these for Pauley can be calculated as follows: Net annual operating revenue ($150,000 – $100,000) $50,000 Less:? income tax expense ($50,000 × 40%) (20,000) After-tax cash inflow from operations $30,000 The depreciation tax shield is derived as follows: Cost of new equipment ($60,000 + $10,000) $70,000 ? Divided by:? estimated useful life ÷????????4 Annual depreciation expense $17,500 Times:? tax rate ×????40% Annual depreciation tax shield $??7,000 Pauley’s total after-tax operating cash inflow for each year of the project’s life is thus $37,000 ($30,000 + $7,000). In the final year of the project, two additional cash flows must be taken into account, the after-tax proceeds from the disposal of the equipment purchased for the project, and the recovery of working capital devoted to the project. These two additional cash flows can be calculated as follows:
Answer (A) is incorrect because The amount of $37,000 results from ignoring the recovery of initial working capital and failing to consider the sale of the equipment.
Answer (C) is incorrect because The amount of $49,000 results from improperly subtracting salvage value when calculating the depreciable base of the new equipment.
Answer (D) is incorrect because The amount of $50,000 results from failing to subject the proceeds from the disposal of the new equipment to income taxes.
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