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ISSN 1940-204X XYZ Company: An Integrated Capital Budgeting Instructional Case David E. Stout Andrews Chair in Accounting Lariccia School of Accounting & Finance Williamson College of Business Administration Youngstown State University destout@ysu.edu Raymond J. Shaffer Lariccia School of Accounting & Finance Williamson College of Business Administration Youngstown State University rjshaffer@ysu.edu THE COMPANY toyed with the idea of introducing more technologically upto-date equipment that, he thought, could help ameliorate the competitive position of the company. Recently, Chang instituted an activity-based costing (ABC) system and a \"bare-bones\" Enterprise Resource Planning (ERP) system that, among other things, helped the company assess customer profitability and price its products more competitively. A new marketing manager, Maria Sanchez, was hired last year to develop and implement an aggressive product-promotion plan. These combined changes helped turn the company around. Two years ago, to raise capital needed for an expansion of the plant and the modernization of certain equipment key to the manufacturing process, the company went public. The company was enjoying a renewed reputation as a producer of high-quality brass products, sold principally in the southeast region of the U.S. XYZ was, in fact, profitable in each of the past four years.1 At the end of the most recent year, total assets were approximately $10 million. Over the past two years, sales for the company amounted to approximately $25 million per year. The company's fiscal year corresponds to the calendar year. XYZ Company was formed in the United States seven years ago by Jim Smith, Marsha Chang, and Earl Watson, who together purchased a commercial machine shop that had been in business for more than 40 years but, at the time of the acquisition, was feeling pressure from a variety of new entrants into the markets in which the machine shop competed. Smith had a distinguished military career and felt he could use the skills he acquired in the military to help this business return to its previously highly profitable state. Smith currently serves as the president and CEO of the company. XYZ produces three primary product lines, all of which are made of brass and are water-related: flow controllers, valves, and pumps. Marsha Chang, a long-time friend of Smith and his family, and a practicing CPA (Certified Public Accountant) and CMA (Certified Management Accountant), joined the company as its CFO shortly before the formation of XYZ. Earl Watson, a high school friend of Smith, had worked as the manufacturing supervisor at the company for the past 10 years and, at the request of Smith, decided to stay onboard after the formation of XYZ. Over the past several years, Watson had IM A ED U C ATIO NA L C A S E JOURNAL Jeremy T. Schwartz Lariccia School of Accounting & Finance Williamson College of Business Administration Youngstown State University jtschwartz@ysu.edu 1 VOL. 8, N O. 1, ART. 1, MARCH 2015 2 0 1 5 I MA THE PROPOSED INVESTMENT: AN ASSET-REPLACEMENT DECISION assets,\" but DOES decline to take \"bonus depreciation\" (if applicable, and as outlined in IRC 179). \t\u0007 to considering the capital budgeting decision at Prior hand, the company has already committed to $2 million of other capital expenditures for 2015. \t\u0007 simplicity, the timing convention for discounting For estimated after-tax cash flows to present value is: \t\u0007 pre-tax operating cash flows, taxes on pre-tax All cash flows, and income tax effects from depreciation deductions occur at the end of each year. For example, time-period-1 operating cash flows are assumed to be received by XYZ on December 31, 2015. Likewise, taxes on these cash flows as well as time-period-1 tax savings due to MACRS-based depreciation deductions are assumed to occur on December 31, 2015. \t\u0007pportunity costs (if any) associated with the decision O to replace the existing asset are assumed to occur at the end of year 1 (that is, on December 31, 2015). \t\u0007 the old asset is sold, the pre-tax cash inflow from this If sale is assumed to occur at the point of sale (at time period zero, January 1, 2015). By contrast, tax savings associated with the half-year depreciation deduction on the old asset under MACRS are assumed to occur at the end of the year, December 31, 2015. Assume that it is sometime in the fourth quarter of 2014. Watson has presented to Smith and Chang a proposal to purchase a replacement to a machine used to manufacture one of the three products. The existing machine was purchased on January 1, 2013. Assume that the asset replacement, if it occurs, will take place on January 1, 2015. Thus, the issue before Smith, Chang, and Watson is whether to keep the existing machine or to replace it with a new, more technologically advanced machine.2 ADDITIONAL ASSUMPTIONS REGARDING THE CAPITAL BUDGETING DECISION XYZ uses two discounted cash flow (DCF) modelsnet present value (NPV) and internal rate of return (IRR)to assess capital investment proposals, including the current asset-replacement decision. Because XYZ has been a listed company for only a short period of time and is thinly traded, Chang has recommended that, for discounting purposes, the company should use 10% (an estimate of XYZ's after-tax weighted average cost of capital [WACC]). In conjunction with your evaluation of the investment proposal at hand, you can assume the following additional facts: BASE-CASE ANALYSIS: KEEP OR REPLACE THE EXISTING MACHINE? \t\u0007 tax law that governs this decision is the U.S. income The tax law that is (or was) in effect for 2015. \t\u0007 proposed acquisition date is January 1, 2015, which The can therefore be considered \"time period 0\" for purposes of your DCF analysis. \t\u0007 Depreciation on the proposed investment for tax purposes will be calculated using the appropriate rates (to be determined by you) under MACRS half-year convention. As previously noted (see Endnote #2), this means that a half-year's worth of depreciation is taken in the year of asset disposal, regardless of the date of sale within the year. For financial reporting purposes, the straight-line (S/L) method is used to record depreciation charges. \t\u0007 the past two years, the marginal income tax rates Over paid by XYZ are: local 5%, state 10%, and federal 25%. For analysis purposes, assume that marginal tax rates for XYZ will, during the years covered by this case, remain constant and equal to the preceding amounts. \t\u0007 Unless otherwise noted, assume that the company does NOT elect to take advantage of write-offs (if any) allowed by Internal Revenue Code (IRC) 179, \"Election to expense certain depreciable business IM A ED U C ATIO NA L C A S E JOURNAL The current machine, which is being considered for replacement, was purchased on January 1, 2013, for $120,000 with an estimated useful life of 12 years and zero salvage value for financial reporting purposes.3 The estimated disposal value of this machine on January 1, 2015, is $36,000. If not disposed of (i.e., if not sold outright), it is estimated that the current machine could be used for another 10 years (i.e., the same total number of years as its original estimated useful life). The base purchase price for the replacement machine is $170,000.4 Delivery cost for the machine, to be born separately by XYZ, is estimated as $5,000. Installation and testing costs for the new machine are estimated to be $25,000. In the past, XYZ has \"charged\" each major investment project with an administrative fee equal to 10% of the purchase price of the asset (investment). This imputed fee represents an allocation of corporate headquarters' (i.e., \"overhead\") expense. During the discussion of the proposed investment, Watson pointed out that if the company purchases the replacement machine, it is likely to lose some business during the time the old machine is being removed and the 2 VOL. 8, N O. 1, ART. 1, MARCH 2015 replacement machine is installed (and tested). His best guessand it is only a guessis that the contribution margin lost during this time would be $5,000 (pre-tax).5 If the replacement asset is purchased, pre-tax operating cash flows are expected to increase by $35,000 per year.6 The new machine is technologically advanced, which is expected to provide two benefits: (1) a reduction in annual cash operating expenses and (2) an increase in sales volume. The latter is attributable to the greater output capacity of the replacement machine. The new machine has an expected useful life of 10 years.7 inflows associated with each decision alternative. I think we have a pretty good handle on the operating cash flows associated with the existing asset. After all, we've been using that machine now for two years. The operating cash flow estimate associated with the replacement asset, on the other hand, was determined in conjunction with the discussions we had with the sales agent for the new machine, which suggests to me the possibility that those estimates could be, well, overly optimistic. I know we are dealing with a lot of assumptions here. To keep the analysis manageable, let's go with the discount rate we used in our base-case analysis, 10% (after-tax), and let's assume the use of NPV as our decision model. I'm curious as to how sensitive our recommendation is with respect to the assumption we are making regarding the amount of annual pre-tax operating cash inflows associated with the replacement asset. Perhaps we can rely on Excel to help us explore this issue.\" At that point, Watson said: \"Two-plus years ago I was involved in the decision to purchase the existing asset. At the time, I remember we factored into the decision the amount of 'net working capital' we thought necessary to support the increased sales volume associated with our investment. I also remember that the amount was something like $20,000. I'm not really sure what this is all about, but I'm thinking that we should at least address this issue. At a minimum, I think we should answer some questions: (1) Conceptually, do we need to amend our base-case analysis to incorporate this information? Why or why not? (2) Assuming we replace the existing asset with the new machine, we would have to commit another $20,000 of (net) working capital to support the anticipated increase in sales. Would this affect our recommended course of action?\" Before the meeting concluded, Smith commented: \"Since we're on the subject, does anyone here think it's strange that we're assuming, in our base-case analysis, that the useful life of each assetboth the existing asset and the replacement assetare equal, that is, 10 years? I would agree that the existing asset is likely to last another 10 years. But I'm not so sure about the replacement asset. Yes, it's supposed to be more efficient, and it's supposed to increase our sales volumehence the additional projected pre-tax operating cash inflows each year. But I did some research on my own recently, and, on the basis of this research, I feel that a more conservative estimate of the useful life of the replacement asset may be eight rather than 10 years. So, if this is true, we're now left with the unfortunate situation of having to compare two assets of unequal lives. How do we do this analytically?\" DEALING WITH UNCERTAINTY: SENSITIVITY ANALYSIS The decision team is aware that many assumptions will be going into the DCF analysis of the present assetreplacement decision.8 Team members are therefore curious as to how sensitive the replacement decision is with respect to each of the following issues or considerations: \t\u0007 discount rate (WACC) used to estimate the present The value of after-tax cash flows; \t\u0007 amount of annual after-tax operating cash inflow The associated with each investment alternative (keep vs. replace); \t\u0007 estimated useful life of each of the two assets (i.e., The these lives may be different); and \t\u0007 possible need to account for an additional The investment in (net) working capital should the company purchase the replacement machine. In terms of the assumed discount rate, Watson offered the following observations at a recent business meeting with Smith and Chang: \"OK, we see that on the basis of our DCF analysis one decision option is preferable (in a present-value sense). This analysis assumed an after-tax discount rate (i.e., a WACC) of 10%. Is this the correct amount? Does the rate we use 'matter' in terms of our assessment of the present investment proposal? Over the weekend, I came across a Harvard Business Review article that suggested we might have to give more thought to this issue.9 What do you folks think?\" At the next planning meeting, Watson raised another sensitivity-analysis issue: \"Well, we addressed the issue of how sensitive our recommended course of action would be in terms of the assumption regarding the discount rate used in our DCF decision models. It seems to me, however, that there are other areas of concern regarding the numbers we used in our base-case analysis. Key concerns among these might be the 'guestimates' we are makingand up to 10 years out!regarding the annual pre-tax operating cash IM A ED U C ATIO NA L C A S E JOURNAL 3 VOL. 8, N O. 1, ART. 1, MARCH 2015 The meeting then concluded. All three team members felt comfortable that the team had identified the primary sources of uncertainty regarding the NPV analyses they were about to conduct. At the request of Chang, the next team meeting would be devoted to raising tax-related questions regarding the proposed acquisition. Chang continued, \"Speaking of additional tax-related issues, I recently read somethingin the Bozeman Daily Chronicle of all places!that might apply to our situation: using a so-called STARKER escrow in conjunction with a possible disposal of our existing asset. I never heard of such a thing, but I'm intrigued about this possible tax-related option. I wonder whether this STARKER thing would apply to our situation.\" ADDITIONAL TAX CONSIDERATIONS STRATEGIC/QUALITATIVE CONSIDERATIONS: BEYOND THE \"NUMBERS\" At the end of the following week, the team reconvened to discuss three tax-related issues that arose from their informal conversations during the week: (1) the issue of \"like-kind exchanges,\" (2) the possibility of taking an accelerated writeoff, and (3) the possible use of a \"STARKER escrow\" for the sale of the existing machine (if the decision were made to replace that machine). Smith began the meeting by saying: \"Well, we've covered a lot of ground here so far, but I wonder whether we're missing something important from a tax standpoint. For example, our baseline DCF analysis assumes that we're going to sell the existing asset outright in the open market. In fact, we have a firm offer from a reputable buyer for the existing machine. But I wonder: (1) Would there be any tax advantage to trading in (rather than selling outright) the old asset, under the assumption that the trade-in amount would be equal to, say, the agreedupon external sales price, $36,000? (2) If we were to negotiate a trade-in value, what would the breakeven value be? That is, can we come up with the trade-in value that would make us indifferent between keeping and replacing the existing asset? To make the analysis tractable, let's assume data associated with our base-case scenario and the use of NPV analysis to address this question.\" Chang agreed that Smith's point was interesting and worth exploring. She pointed out that the relevant tax law pertaining to this issue is covered in IRC 1031, \"Exchange of property held for productive use or investment.\" Smith continued, \"I also recall that two years ago, when we purchased the existing machine, we talked about expensing the machine immediately, under (I think) IRC 179. I don't remember the details, but I do remember someone making the point that this election could have saved us more than a trifling amount in terms of our tax bill. I really can't remember why we chose not to go that route. Chang, in your opinion, is this option available this year? Would it benefit us? Why or why not? I think we need to address these questions as we evaluate the present investment opportunity.\" Chang replied, \"I remember an article from a couple of years ago that dealt with these very issues.10 I'll retrieve and reread itit may be relevant to the present decision analysis.\" IM A ED U C ATIO NA L C A S E JOURNAL Then, Smith commented: \"I think we've done a pretty good job covering all of the financial dimensions of the present decision, including some interesting income tax considerations. As agreed to in our earlier meetings, our basecase analysis will be supplemented with various sensitivity analyses. At this point, I think we should ask ourselves whether we've covered all relevant aspects of the proposed decision. Why don't we call in Mark Callaway to see whether we are missing something heresomething that goes beyond the 'numbers'? I'm concerned, for example, about whether we have properly considered any pertinent strategic or qualitative considerations.\" Smith knows that, at a minimum, it will be prudent to consult with Mark Callaway, director of Investor Relations for XYZ. After hearing the back story for the proposal and examining the underlying data discussed thus far by the team, Callaway skeptically responds, \"We have been profitable the past two years with the current machine. What you are proposing is giving me a public relations headache if we sell the old machine, we could very well take a hit on our published financial statements for the first quarter of 2015 and perhaps beyond.\" Smith interjects, \"On paper, Callaway. The sale of the existing machine would actually provide a tax benefit.\" Callaway responds, \"Yes, we record a loss for financial reporting purposes, but it's truly a loss since we paid $120,000 for the machine, used it for only two years, and now will receive only $36,000 for it. That's quite a rental fee!\" Smith concedes, \"You have a point there.\" Callaway continues, \"We are also pushing aside business during the transition period.\" Watson speaks up. \"Temporarily, this should only be a minor delay.\" Callaway retorts, \"So you say. Forgive me for my skepticism, but I would be concerned about how long this 'minor' delay will be. You were the one who promoted the current machine, which is supposed to last another decade 4 VOL. 8, N O. 1, ART. 1, MARCH 2015 but now isn't good enough? Two years ago we raised capital in part by promising profits through use of the current machine, which profits you have delivered thus far. Now, you're asking the company to cough up even more money for a replacement machine, which may or may not be more profitable. As well, you're telling me that the new machine may actually have a shorter useful life than the existing machine it's supposed to replace.\" Watson rejoins, \"It will be more profitable. As noted in the DCF analysis we performed, we anticipate having both operational cost savings and increased sales volume due to increased capacity of the new machine.\" Callaway shakes his head, saying, \"Look, I think it's great that you're looking for ways to increase the value the company and our bottom line. I'm concerned, however, that you're being overly optimistic. Do you have a handle on how many more units we can sell? Will the cost savings allow us to reduce price to the point where we maintain margins? Best-case scenario, we take a step back only in the next quarter, entirely due to changing the machines. Worst-case, the new machine enables us to produce much more than we can sell, and we're stuck squeezing margins to move our products.\" Smith intercedes, \"But, we have a real opportunity for growth with the new equipment.\" Callaway responds, \"Yes, but is bigger really better? I'm leery of making this proposed financial commitment. So much has to go right for us. Let's assume that Watson is right about the cost savings from using the new machine. That would be great, but for what production range will that be valid? Will we really be able to sell enough to make it worthwhile?\" Watson remains emboldened, \"I guarantee that the replacement machine will be worth it. You're focusing too narrowly on the short-term adjustment period.\" Callaway replies, \"Yeah, but how do I know that you won't come back again in two years asking the shareholders to buy another toy that you say will last 10 years?\" Smith brings the matter to a close. \"Callaway, we'll take your concerns under advisement. I'm confident that you'll be effective in explaining to our investors any short-term hiccups in profits. But we're putting the cart before the horse here. I think that Watson, Chang, and I need to run the numbers to assess the short-term financial-reporting effect of our decision.\" As Callaway walks off, Smith turns to Chang and Watson: \"Our earlier discussion with Callaway has made me step back a bit and think more broadly about the decision we're facing. My sense is that it would be worthwhile for us to supplement our financial analysis with a listing of strategic and/or qualitative factors that are associated with this decision. I guess my IM A ED U C ATIO NA L C A S E JOURNAL concern is whether 'the numbers' capture all pertinent aspects of this decision. What do you think? At a minimum, I suggest we address the following questions: (1) Are there important strategic considerations associated with each decision alternative? If so, what are they? (2) If the answer is 'yes,' have we already captured the effect of these factors in our financial analysis? If not, what exactly do we do with this information? That is, is there a way for us to incorporate both financial and nonfinancial information formally into our decision process?\" Chang and Watson agreed that these were legitimate questions to address in conjunction with the proposed acquisition. PROJECT EVALUATION SUMMARY At the conclusion of the meeting, Watson said: \"We've really covered a lot of territory here, to the point that we now have what might be viewed as a bewildering array of facts, figures, and calculations. Can we put our heads together and craft a useful summary of our analysesperhaps in the form of a table? I know I'd find this very helpful. I think this would be a nice way to prepare for the final meeting, at which time we'll make a decision regarding the asset replacement.\" Smith and Watson agreed to work with Chang over the next few days to prepare a project evaluation summary report that could be used to guide the discussion scheduled for the following week. CASE REQUIREMENTS 1.\t\u0007Base-case analysis:11 Should the replacement asset be purchased? That is, does it make economic (financial) sense for XYZ to replace the existing machine? Support your answer by clearly showing the tax basis of the replacement asset (if purchased and under the assumption that the existing asset would be sold outright rather than traded in) and the annual after-tax cash flows associated with both decision options. Remember to record appropriate depreciation expense under MACRS for the existing asset, assuming it is sold January 1, 2015. Recall that the pre-tax cash flow from the disposal of the existing asset is assumed to occur on January 1, 2015, while the tax savings due to depreciation deductions under MACRS, as well as tax-related effects of the disposal (if any), are assumed to be realized at the end of 2015. Base your recommendation on both an NPV analysis and a comparison of the IRR associated with each of the two investment alternatives (keep vs. replace). Comment on your comparative results. Round all calculations, including intermediate calculations, to whole numbers (i.e., to zero decimal points). 5 VOL. 8, N O. 1, ART. 1, MARCH 2015 2.\t\u0007Dealing with Uncertainty/Sensitivity Analysis: 3.\t\u0007Additional Tax-Related Issues: a. Issues related to the discount rate: How (conceptually) \u0007 is the discount rate for capital budgeting purposes defined and calculated? Is this number appropriate for analyzing the asset-replacement decision at hand? Why or why not? What impact, if any, would a rate below or above 10% have on the recommended course of action for XYZ Company? To address this issue, first prepare a schedule in Excel showing what the NPV results of the base-case analysis would be after letting the WACC vary from a low of 8% to a high of 13%, in increments of 1%. For each discount rate, recalculate the difference in NPV of the two investment alternatives. Next, use the Data Table option in Excel to perform and present the results of this sensitivity analysis. Finally, using the Goal Seek option in Excel, determine the \"breakeven\" discount rate, that is, the rate that would make XYZ indifferent between the two decision options (based on an NPV analysis of the base-case facts). supporting calculations (if appropriate) to the two taxrelated questions raised by Smith in conjunction with the possibility of trading in rather than selling the existing machine outright (if the new machine were purchased): (1) Would there be any tax advantage to trading in (rather than selling) the old asset? (2) What would the breakeven value of the trade in be? Note: When responding to Smith's second question, assume base-case data. For purposes of responding to this question, you can ignore the incremental investment in net working capital (if any) that would be required if the new asset is purchased. b. Estimates of annual pre-tax cash inflows of the \u0007 authoritative support, to Chang's issue regarding the STARKER escrow: What is it and is it applicable to the present situation? 4.\t\u0007 Strategic and/or Qualitative Considerations/Multi-Criteria Decision Models: c. \u0007 ddressing incremental investment in (net) working A capital: Respond to the two queries raised by Watson a. Incentive effects: Calculate the book loss (i.e., the loss for \u0007 financial reporting purposes) that Callaway references regarding the disposal (i.e., the outright sale) of the old machine. What effect should the book value have on the decision to purchase the new machine? How will external users, such as shareholders, likely react to this information? What incentive does Watson have in representing the length of time for retooling? How might the present decision affect customer relations? What general issue regarding incentive effects and the design of management accounting control systems is raised by this example? regarding the possible need to make an up-front commitment of additional (net) working capital if the replacement machine is purchased: (1) Does the base-case analysis need to be changed? Why or why not? (2) If the team replaces the machine, XYZ would have to commit to incremental (net) working capital of $20,000. Would this incremental investment affect the recommended course of action? (Show calculations.) d. Unequal asset lives: Under the assumption that the \u0007 useful lives of the two assets differ, a possibility noted by Smith, and based on the use of the NPV decision model, provide a recommendation as to which asset XYZ should choose. Support your answer with appropriate calculations and citations to the literature. IM A ED U C ATIO NA L C A S E JOURNAL c. Use of a STARKER escrow in conjunction with the \u0007 disposal of the existing asset: Prepare a response, with Excel to determine the breakeven operating pre-tax cash inflow associated with the replacement asset (i.e., the annual pre-tax cash inflow for the replacement machine that would make XYZ indifferent between keeping vs. replacing the existing machine). What keen managerial insight is yielded from this analysis? b. \u0007 pplicability of IRC 179: Prepare a response, with A appropriate authoritative support, to the two questions raised by Smith regarding the provisions of IRC 179, as it pertains to expensing of the cost of the replacement asset: Does XYZ have this option? What are the benefits of this option (if any)? replacement machine: Use the Goal Seek option in a. Like-kind exchanges, IRC 1031: Prepare a response with \u0007 b. Demand and pricing-related considerations: Expand on \u0007 Callaway's criticisms from a strategic perspective. For example, what does he mean by \"squeezing margins\"? What economic assumption regarding price elasticity of demand is XYZ making for its products? How does XYZ balance its desire to gain market share through cost efficiencies with the \"commitment\" it made to shareholders regarding the original machine? 6 VOL. 8, N O. 1, ART. 1, MARCH 2015 Currently, there is no sales tax in the state in which XYZ is located. 4\u0007 c. \u0007 dditional qualitative/strategic considerations and the use of A multi-criteria decision models: Prepare a response to the two questions raised by Smith regarding strategic/qualitative considerations associated with the proposed investment: (1) What additional nonfinancial/strategic factors (beyond those discussed in 4(a) and 4(b)) might bear on the decision facing XYZ Company? (2) How could such factors (if any) be formally incorporated into a capital budgeting analysis? To the extent possible, support your position by offering several additional qualitative/strategic considerations and by referencing the appropriate literature (e.g., the literature pertaining to \"multi-criteria decision making\" models as applied to a capital budgeting context). For simplicity (as noted above), assume that these effects occur at the end of year 1 (i.e., on December 31, 2015). 5\u0007 Pre-tax operating cash inflows from using the new machine are estimated as $55,000 per year. Pre-tax operating cash inflows from using the existing machine are assumed to be $20,000 per year. 6\u0007 Note that this can be different from the period over which depreciation on the asset is recorded under MACRS for U.S. income tax purposes. 7\u0007 In structuring the DCF analysis of the present assetreplacement decision, you may want to consult a corporate finance or intermediate-level financial management textbook and/or the following article: Su-Jane Chen and Timothy R. Mayes, \"A Note on Capital Budgeting: Treating a Replacement Project as Two Mutually Exclusive Projects,\" Journal of Financial Education, Spring/Summer 2012, pp. 56-66. 8\u0007 5.\t\u0007 Project Evaluation Summary: Prepare a summary report (in the form of a table) that reflects the major issues addressed in the case. Each row in your table should deal with a separate issue you addressed. For each issue, provide a statement as to whether and why (or how) the issue at hand would affect the recommended decision as well as any additional information you think is pertinent. Assume that the document you prepare would be the type that could be used to guide the discussion at the decision team's final meeting (or the presentation of your report to a client) and that the project evaluation summary would be supported by the various analyses conducted in conjunction with answering previous case questions. Michael T. Jacobs and Anil Shivdasani, \"Do You Know Your Cost of Capital?\" Harvard Business Review, July 2012, pp. 118-124. 9\u0007 Richard Mason, Sonja Pippin, and Anthony Curatola, \"Expensing vs. Capitalizing Business Property in Light of ATRA,\" Strategic Finance, April 2013, pp. 8-12. 10 \u0007 ENDNOTES Note that all tax-related questions and calculations in the case pertain to U.S. tax law in effect at the indicated date. This law may change over time (which suggests the need for accountants to maintain up-to-date knowledge in the area). Further, the tax laws in effect in countries other than the U.S. may produce different results from those based on U.S. tax law. 11 \u0007 As such, the company currently has no operating loss carryforwards for U.S. tax purposes. 1\u0007 By the time of the investment decision (January 1, 2015), the machine in question would have recorded two years' worth of depreciation for financial reporting purposes and two and a half years' worth of MACRS-based depreciation for tax purposes. Under current MACRS rules, a half-year of depreciation is taken in the year of asset disposal. Since the proposed transaction is assumed to occur on the first day of the fiscal year, under MACRS (Modified Accelerated Cost Recovery System) XYZ would record a half-year of depreciation expense for the existing asset for tax purposes for 2015. 2\u0007 ABOUT IMA (Institute of Management Accountants) IMA, the association of accountants and financial professionals in business, is one of the largest and most respected associations focused exclusively on advancing the management accounting profession. Globally, IMA supports the profession through research, the CMA (Certified Management Accountant) program, continuing education, networking and advocacy of the highest ethical business practices. IMA has a global network of more than 75,000 members in 120 countries and 300 professional and student chapters. Headquartered in Montvale, N.J., USA, IMA provides localized services through its four global regions: The Americas, Asia/Pacific, Europe, and Middle East/Africa. For more information about IMA, please visit www.imanet.org Annual depreciation expense for financial reporting purposes = (Purchase price - Salvage Value) / Useful Life. In the present case, depreciation charges = ($120,000 $0) / 12 years = $10,000 per year. 3\u0007 IM A ED U C ATIO NA L C A S E JOURNAL 7 VOL. 8, N O. 1, ART. 1, MARCH 2015