A group of businessmen formed a corporation to lease for 5 years a piece of land

Question

A group of businessmen formed a corporation to lease for 5 years a piece of land at the intersection of two busy streets. The corporation has invested $50,000 in car-washing equipment. They will depreciate the equipment by sum-of-years’ digits depreciation, assuming a $5,000 salvage value at the end of the 5-year useful life. The corporation is expected to have a before-tax cash flow, after meeting all expenses of operation (except depreciation), of $20,000 the first year, declining $3,000 per year in future years (second year = $17,000; third year = $14,000; etc.). The corporation is taxed at a combined corporate tax rate of 20%. If the projected income is correct, and the equipment can be sold for $5,000 at the end of the 5 years, what after-tax rate of return (to the nearest 1%) would the corporation receive from the venture?

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Explanation / Answer

Calculation of Rate of Return on Venture:

Step 1: Calculation of Depreciation:

Sum of Years Digit Method:

As per this method we need to calculate a sum of years digit i.e. SYD which is given by the formula n(n+1)/2, where n is the useful life of the asset.

Given that n = 5 years,

therefore SYD = 5(5+1)/2 = 15.

Now,we consider depreciation for each year upon the sum of years which is 15 (1+2+3+4+5)

Step 2: Computation of After Tax Rate of Return:

Rate of Return on Investment = Net Cash flow after Tax/Initial Investment

Rate of return on investment (%) = 24000/50000*100 = 48%

Depreciation schedule Year Remaining Useful Life (at beginning of the year) Sum of Years Digit Applicable Percentage Annual Depreciation amount 1 5 5/15 33.33% 15000 2 4 4/15 26.67% 12000 3 3 3/15 20% 9000 4 2 2/15 13.33% 6000 5 1 1/15 6.67% 3000

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