Assume the following for a piece of equipment assuming straight-line depreciation: Purchase price $20,000; installation costs of $2,500; 4-Yr useful life with an estimated salvage value of $4,500; tax rate 40%; What would be the cash flow from salvage if the asset sold after 2 years for (a) $15,500 and (b) $7,000?

a. $14,700

b. $9,600

Explanation:

Total cost of the equipment = Purchase price + installation costs = $20,000 + $2,500 = $22,500

Salvage value = $4,500

Amount to be depreciated = $22,500 - $4,500 = $18,000

Depreciation rate = 1 ÷ 4 = 0.25, or 25%

Annual depreciation = $18,000 × 25% = $4,500

Equipment book value after 2 years = $22,500 - ($4,500 × 2) = $13,500

(a) What would be the cash flow from salvage if the asset sold after 2 years for $15,500

Gross profit on equipment disposal =  Sales amount - Equipment book value = $15,500 - $13,500 = $2,000

Tax = $2,000 × 40% = $800

Net profit on equipment disposal = $2,000 - $800 = $1,200

Cash flow = Equipment book value + Net profit on equipment disposal = $13,500 + $1,200 = $14,700

(b) What would be the cash flow from salvage if the asset sold after 2 years for $7,000

Loss on equipment disposal =  Sales amount - Equipment book value = $7,000 - $13,500 = $6,500

Tax shield difference = $6,500 × 40% = $2,600

Cash flow = $7,000 + $2,600 = $9,600