Question

Consider an asset with the following cash flows:

	Year 0	Year 1	Year 2	Year 3
Cash flows ($ millions)	−60	26.00	24.00	22.00

The firm uses straight-line depreciation. Thus, for this project, it writes off $20 million per year in years 1, 2, and 3. The discount rate is 10%.

1. Complete the following table.

2. Does the economic depreciation equal the book depreciation?

3. Is the book rate of return the same in each year?

4. Is the project's book profitability its true profitability?

Answer 1

	Year 0	Year 1	Year 2	Year 3
Cash flows ($ Millions)	-60	26.00	24.00	22.00

#1.

-Economic depreciation is a measure of the decrease in the market value of an asset over time from influential economic factors.Economic depreciation is different than accounting depreciation. In accounting depreciation, an asset is expensed over a specific amount of time, based on a set schedule.

-Calculating economic depreciation is not always as simple as in accounting depreciation. In accounting depreciation, a tangible asset’s value decreases over time based on a set depreciation schedule. With economic depreciation an asset’s decreases in value are not necessarily uniform or scheduled but rather based on influential economic factors.

Depreciation in economics is a measure of the amount of value an asset loses from influential factors affecting its market value. Asset owners may more closely consider economic depreciation over accounting depreciation if they seek to sell an asset at its market value.

-Economic depreciation affects the selling value of an asset in the market. It may be followed and tracked by asset owners. In business accounting, economic depreciation is not typically notated on financial statement reporting for large capital assets since accountants usually use book value as the primary reporting method.

- Hence from the above we can conclude that the ecnomic depreciation is not equals to book depreciation.

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#2.

Book rate of return = Cash flows or net profit / investment

	Year 1	Year 2	Year 3	Total
Cash flows($Million) (A)	26.00	24.00	22.00	72.00
Investment($Million) (B)	60.00	60.00	60.00	60.00
Book rate of return(A/B)	43.33%	40.00%	36.67%	120%

Hence book rate of return is not same in same year.

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#3.

-Projects book profitability is not its true profitability. Book profitability does not take into consideration the discounting rate, and cost of capital.

-Actual or true profitability is calculated by using the projects NPV or net present value.

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# Calculation of book profit

	Cash flow ($ Million)
Year 1	26.00
Year 2	24.00
Year 3	22.00
Total Cash flow	72.00
Total Investment	60.00
Book profit	=72-60 =$12 million

# Calculation of NPV or true profit

	Cash Flow($Million)	PVF@10%	Present value of cash flow
Year 0	-60.00	1	-60.00
Year 1	26.00	0.909	23.636
Year 2	24.00	0.826	19.835
Year 3	22.00	0.751	16.529
		Total	0

Here precent value of the cash inflows is equal to present value of cash outflow or the investment.

Hence there is no profit or loss.

True profit or NPV = ZERO