- CFA Exams
- CFA Level I Exam
- Study Session 7. Corporate Finance (1)
- Reading 19. Capital Budgeting
- Subject 1. Cash flow projections

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**CFA Practice Question**

HC Ltd. purchased a machine 5 years ago at a cost of $80,000. The machine had an expected life of 15 years at the time of the purchase, and an expected salvage value of $5,000 at the end of the 15 years. It is being depreciated by the straight-line method toward a salvage value of $5,000; that is depreciation is $5,000 per year. The machine can be sold for $25,000. A new machine can be purchased for $150,000 including installation costs. During its 10-year life, it will reduce pre-tax cash operating expenses by $30,000 per year. Sales are not expected to change. At the end of its useful life, the machine is estimated to be worth $40,000. Straight-line depreciation will be used to depreciate the machine to salvage value of zero; that is depreciation is $15000 per year. The firm's tax rate is 35 percent. The appropriate discount rate is 15 percent. Which of the following statements is correct?

A. The change in depreciation is $8,000 in each of the next 10 years.

B. The tax savings from depreciation is $2,800 in each of the next 10 years.

C. The net change in after tax operating cash flows are $23,000 in each of the next 10 years.

**Explanation:**The net change in after tax operating cash flows equal the after tax change in the operating expenses plus the tax savings from depreciation.

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**User Contributed Comments**
10

User |
Comment |
---|---|

kalps |
(30,000 X 0.65) + (10,000 X (0.35)) = 23,000 |

evica |
30000x0.65 + (15000-5000)x0.35=23000 |

ravindra |
in this ques just chek the amt increased bcase of new asset, and the benifit from additional depreciation |

george2006 |
net benefit of increase depreciation on CFO is the increased depreciation x TaxRate |

HenryQ |
Cash operating expense goes down, operating income increase by 30000*65 which goes into after tax operating CF, and also more dep shield. |

HenryQ |
After reviewing this again, I think the answer is not correct. The incremental deprecation is actually the 15,000 which is above the old machine's 5000, so why should be calculated by get the difference of the two? |

Rotigga |
No HenryQ, the answer is correct: Change in depreciation = $15,000 - $5,000 = $10,000; kick A Tax savings = $10,000*0.35 = $3,500; kick B Net change in AT CF = AT reduction in op expense + tax savings = $30,000*0.65 + $3,500 = $23,000 C is correct |

MattNYC |
This question fooled me too. Its the NET change in Deprecaation between the 2 options. I was looking at only the Static NOATCF for the machine and couldn't come up with 23,000 |

vi2009 |
Net change in depreciation = 15,000-5,000 = 10,000, or (30000-10000)(0.65)+10000 = 23,000 |

Hishy |
I think it's because the question said what's the net CHANGE in after-tax operating cashflows, so you have to compare the effects of both machines. If the question asked you to simply calculate the after-tax OCF, then it would just be (30,000-15,000)*.65+15,000 = 24,750 |