Examine the correct analysis in Exhibit 11.6. Suppose the cash-operating inflows persisted for an extra year. Compute the PV of the inflow for the sixth year. Ignore depreciation.

Exhibit 11.6

Transcribed Image Text:

Description Correct analysis (Be sure the discount rate includes an element attributable to inflation and adjust the predicted cash flows for inflationary effects.) Cash operating inflows: Pretax inflow in 20X0 terms Income tax effect at 40% After-tax effect on cash Subtotal Annual depreciation €200,000÷5=€40,000 Cash effect of depreciation Savings in income taxes at 40% = €40,000 x .40 = €16,000 Investment in equipment Net present value Incorrect analysis (A common error is to include an inflation element in the discount rate as above, but not adjust the predicted cash inflows.) Cash operating inflows after taxes Tax effect of depreciation Investment in equipment Net present value €83,333 33,333 €50,000 PV factor .8000 .6400 5120 4096 3277 2.6893 1.0000 2.6893 2.6893 1.0000 At 25% Present value € 44,000 38,720 34,074 29,985 26,388 €173,167 43,029 (200,000) € 16,196 €134,465 43,029 (200,000) € (22,506) 0 (€200,000) (€200,000) Sketch of relevant cash flows (at end of year) 1 €55,000* €16,000¹ €50,000 16,000 2 €60,500 €16,000 €50,000 16,000 3 €66,550 €16,000 €50,000 16,000 *Each year is adjusted for anticipated inflation: €50,000 x 1.10, €50,000 x 1.10², €50,000 x 1.10³, and so on. *Inflation will not affect the annual savings in income taxes from depreciation. Why? Because the income tax deduction must be based on original cost of the asset in 20X0 terms. 4 €73,205 €16,000 €50,000 16,000 5 €80,526 €16,000 €50,000 16,000 Activate Go to Sett