Problem:
Roethlis Partners has compiled the following data for a potential venture:
Investment: $20,000; 5-year useful life, with no salvage value;
Annual Sales Revenue = $10,000; Annual Cash Costs = $4,200
Roethlis imposes a required rate of return of 10%. Roethlis faces a 20% tax rate on income, and knows that the tax authorities will only permit straight line depreciation for tax purposes.
a. Is this a project Roethlis would benefit from taking on?
b. Suppose that Roethlis uses straight line depreciation for internal accounting. Demonstrate the conservation property of residual income in this setting, and also show that strict goal congruence is not achieved.
c. For internal purposes alone, suppose that Roethlis switches to a schedule whereby depreciation charges increase over time at a compound rate of 10% (the cost of capital). Compute the depreciation amounts under this plan and show that they lead to strict goal congruence.
(Hints: For internal purposes, let income equal after-tax cash flows (less) depreciation. Note that the proposed depreciation schedule affects the depreciation amounts, net book values and, as a result, the capital charges; however, it has no impact on cash taxes paid, or cash flows in general).