In year 1, Firm A paid $50,000 cash to purchase a tangible business asset. In year 1 and year 2, it deducted $3,140 and $7,200 depreciation with respect to the asset. Firm A’s marginal tax rate in both years was 21 percent. Now assume that Firm A borrowed $50,000 to purchase the asset. In each year, it paid $3,800 annual interest on the debt. The interest payments were deductible.

Solution and Explanation:

a.Compute Firm A’s net cash flow attributable to the asset purchase in each year.Year 2011:

Cost of Asset  = ($50,000)

Tax Savings (Annual Depreciation x Tax Rate)  = $1,099

Net Cash Flow  = ($48,901)

Year 2012:

Cost of Asset   = N/A

Tax Savings (Annual Depreciation x Tax Rate) ()  = $2,520

Net Cash Flow = $2,520

b. Compute Firm A’s adjusted basis in the asset at the end of each year.

INITIAL COST OF ASSET = $50000

DEPRECIATION YEAR 1 = (3140)

ADJUSTED BASIS AT END OF YEAR 1 = $46860

YEAR 2 DEPRECIATION = (7200)

ADJUSTED BASIS AT END OF YEAR 2 = $39660

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