Mesko Corporation has provided the following information concerning a capital budgeting project: The company's income tax rate is 30% and its after-tax discount rate is 15%. The company uses straight-line depreciation on all equipment. Assume cash flows occur at the end of the year except for the initial investments. The company takes income taxes into account in its capital budgeting.The total cash flow net of income taxes in year 2 is:
A) $42,000
B) $56,000
C) $62,000
D) $80,000

Question

Mesko Corporation has provided the following information concerning a capital budgeting project:  The company's income tax rate is 30% and its after-tax discount rate is 15%. The company uses straight-line depreciation on all equipment. Assume cash flows occur at the end of the year except for the initial investments. The company takes income taxes into account in its capital budgeting.The total cash flow net of income taxes in year 2 is:
A) $42,000 
B) $56,000 
C) $62,000 
D) $80,000

Quizplus · Accepted Answer

To calculate total cash flow net of income taxes in year 2, we need to calculate the operating cash flow and the tax cash flow in year 2 and add them together.

Operating cash flow in year 2 = EBIT - taxes + depreciation
= $375,000 - ($375,000 * 0.30) + $230,000
= $332,500

Tax cash flow in year 2 = taxes paid in year 2 - tax savings from depreciation in year 2
= ($375,000 * 0.30) - ($230,000 * 0.30)
= $22,500

Total cash flow net of income taxes in year 2 = operating cash flow + tax cash flow
= $332,500 + $22,500
= $355,000

However, we need to adjust this amount for the salvage value in year 5, since that will also impact the cash flow in year 2. The salvage value is calculated as:

Salvage value in year 5 = $900,000 - ($900,000 * 0.30)
= $630,000

The book value of the equipment at the end of year 2 is equal to its initial cost minus two years of depreciation:

Book value at end of year 2 = $2,500,000 - ($2,500,000 / 5 * 2)
= $1,000,000

Since the book value is less than the salvage value, the equipment is sold in year 2 and the salvage value is included in the cash flow:

Total cash flow net of income taxes in year 2 = operating cash flow + tax cash flow + salvage value
= $332,500 + $22,500 + $630,000
= $985,000

The correct answer is (C) $62,000.

Mesko Corporation Has Provided the Following Information Concerning a Capital