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ACC602: Strategic Management Accounting: Week 10: Topic 7

WSPI is considering investing $400,000 in equipment for a 5-year contract to build scientific instruments. They must also invest $50,000 in working capital. Net cash flows are provided for each of the 5 years. The tax rate is 40%. Depreciation of the equipment is $80,000 per year using straight-line method. Depreciation is a non-cash expense but provides a tax benefit. Using a 10% discount rate, the NPV of the after-tax cash flows is negative, indicating the investment is not financially worthwhile. However, investments may still be approved for qualitative reasons or if they have the lowest cost option.

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41 views

ACC602: Strategic Management Accounting: Week 10: Topic 7

WSPI is considering investing $400,000 in equipment for a 5-year contract to build scientific instruments. They must also invest $50,000 in working capital. Net cash flows are provided for each of the 5 years. The tax rate is 40%. Depreciation of the equipment is $80,000 per year using straight-line method. Depreciation is a non-cash expense but provides a tax benefit. Using a 10% discount rate, the NPV of the after-tax cash flows is negative, indicating the investment is not financially worthwhile. However, investments may still be approved for qualitative reasons or if they have the lowest cost option.

Uploaded by

Azmeena Fezleen
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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ACC602: Week 10: Topic 7

STRATEGIC MANAGEMENT Evaluating Further Aspects Of

ACCOUNTING Investment Decisions


TOPIC OVERVIEW
- impact of income taxes on capital budgeting decisions
Firms that pay income taxes must consider the impact
income taxes have on cash flows for long-term investments. 

How do for-profit organizations include income taxes in


their analysis when making long-term investment decisions?

Let’s look at an example:


The management of West Scientific Products, Inc. (WSPI), is
considering a five-year contract to build scientific instruments for a
large school district.

The initial investment required to purchase production equipment is


$400,000 (to be depreciated over 5 years using the straight-line
method, with no salvage value).

An additional $50,000 in working capital is required for the contract.


Working capital will be returned to WSPI at the end of five years.

Annual net cash receipts from daily operations (cash receipts


minus cash payments) are shown on the next slide.
Year Net Cash Flow
1 $50 000 Note: Since
2 $60 000 depreciation expense
3 $120 000 is not a cash outflow, it
4 $200 000
is not included in these
5 $130 000
amounts .
(depreciation is a non-cash item)

Required rate of return of 10 percent for this proposal.

The tax rate applicable in case is 40 percent.

Required: Analyze WSPI investment using after tax cash flows for NPV?
Impact of tax on Net cash flow
Net cash receipts is a benefit,
will lead to increase in profit
Tax rate of 40% (based on the information on slide 4)

(the company will be charged tax on the benefits, therefore payment of tax in the future years
based on the benefits will be considered as future cash outflow)

Timeline Year 1 Year 2 Year 3 Year 4 Year 5


Leads to increase in
Net cash flow $50,000 $60,000 $120,000 $200,000 $130,000 profit
Less Tax of 40% $20,000 $24,000 $48,000 $80,000 $52,000Cost
Annual after-tax cash receipts $30,000 $36,000 $72,000 $120,000 $78,000Benefit
Impact of tax on Depreciation and Capital expenditure decisions
Straight line Depreciation

= $400 000/5

= $80 000 per annum

Note: Depreciation is a non-cash item therefore there is no outflow of cash

But Depreciation is an expense which will have impact on profit

therefore, there will be cost savings, depending on the tax rate.

Timeline Year 1 Year 2 Year 3 Year 4 Year 5

Annual Depreciation $80,000 $80,000 $80,000 $80,000 $80,000Cost

Tax savings of 40% $32,000 $32,000 $32,000 $32,000 $32,000Benefit


Full analysis for NPV after-tax cash flows
Full analysis for NPV after-tax cash flows
Future cash flows

Year 0
(Today or at
Timeline present) Year 1 Year 2 Year 3 Year 4 Year 5
Purchase Price (Initial invetsment) $(400,000)         
Working Capital (50,000)        $50,000
Annual after-tax cash receipts   $30,000 $36,000 $72,000 $120,000 $78,000
Annual depreciation tax savings   $32,000 $32,000 $32,000 $32,000 $32,000
Total cash inflows (outflows) $(450,000) $62,000 $68,000 $104,000 $152,000 $160,000
Present value (PV) r=10% 1 0.9091 0.8264 0.7513 0.683 0.6209 NPV
Present value $(450,000) $56,364 $56,195 $78,135 $103,816 $99,344$(56,146)

Since NPV is negative, the investment not worthwhile on financial grounds.

Go through the supplementary readings.


CAPITAL BUDGETING AND LEAST COST
DECISIONS
In some situations, capital expenditure may be approved even when there is a negative NPV (or
less than acceptable IRR).

These decisions may be of benefit to the business and would be taken on the basis of;

 Qualitative concerns may be driving the investment

 Select the course of action that has the lowest cost

 Rather than maximising the NPV of cash inflows minus cash outflows, the objective is
to minimise the NPV of the costs to be incurred
AMENDED ACC602 COURSE ASSESSMENT PLAN
Assessment Components                             Weighting                Due Date
1. Individual Assignment                               10%                   Week 6 (completed)
2. Online Participation Quiz                           5%                     Online quiz
                                                                                              (closes on 14/05/2021)
3. Mid Semester Exam                                  20%                     Week 7 (completed)
4. Online Quiz (Topics 6 & 7)                       15%                     Week 11/12
5. Calculation & Analysis (Topic 8)                 15%                    Week 13
6. Case Study (Topic 9)                                15%                     Week 14
7. Case Study (Topics 10 & 11)                     20%                     Week 16
TOTAL                                                         100%
Please submit / complete all the assessments in a timely manner.
Manage your time efficiently and effectively.
Thank you and should you have any questions you
can post on forum discussions or e-mail or viber.

Go through the supplementary reading and you tube videos.

End of Topic 7.

Complete Online Quiz 15% on Topics 6&7(opens 10/05/2021 and closes on 21/05/2021)

Next …. Topic 8
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