I can’t find this in the CFA errata and I can’t figure out what I’m missing… Reading 31, Question 12: Fontenot Co is investing $100 in a project being depreciated straight-line to zero over a two-year life w/no salvage value. The project will generate earnings before interest & taxes of $50 each year for two years. Fontenot’s WACC and required rate of return for the project are both 12% and its tax rate is 30%. What is the after tax-operating CF in year 1 and year 2? One more… Reading 31, Question 21: Info given: “…Richie Express, which is investing $500,000 all in fixed capital, in a project that will have depreciation and operating income after taxes, respectively, of $40,000 and $20,000 each year for the next three years…” In calculating the answer, the CFA material is including the $20,000 depreciation in the yearly cash flows. e.g. CF = $60,000. I thought maybe the $20,000 was the tax savings but in calculating the BV they are using $20,000 depreciation each year. I know the capital budgeting stuff is easy but I really want to make sure I’m not missing something. Every point on exam day helps. Thanks!
Q1: Income = 50 -Depr = 50 ---------------- EBIT = 0 Tax = 0 ---------------- Add back Depr 50 So AT Operating CF = 50. Q2: They are adding back Depr because Depr is a non-Cash Expense – and you add it back to calculate Cash flows when using the Indirect method of Cash flows. CP
^Actually the question states that EBIT, not net income, is $50. EBIT is after the $50 in depreciation is taken out. You would calculate the answer as follows: EBIT $50 Less Taxes at 30% ($15) Plus Dep $50 Equal AT Operating CF of $85. For Question 2, they state that operating income after taxes is $40K. Since this is after depreciation and taxes, this alread takes into account tax savings from depreciation. You then add back the entire depreciation amount because it is a non-cash expense.
Awesome TMurf, thanks so much! I had a weird feeling that it would have been in the errata if it was truly incorrect. I’ve really got to watch whether it’s CF, operating income, etc. (FSA is not my strong point)
Good eye for detail on the second one TMurf, I saw Operating Income and immediately assumed EBIT.