Question

Consider an asset with the following cash flows:

Year 0 Year 1 Year 2 Year 3

Cash flows ($ millions) −42 18.20 16.80 15.40

The firm uses straight-line depreciation. Thus, for this project, it writes off $14 million per year in years 1, 2, and 3. The discount rate is 10%.

a. Complete the following table.

b. Does the economic depreciation equal the book depreciation?

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

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

Complete the following table
	Year 1 Year 2 Year 3 Cash flow PV at start of year PV at end of year Change in PV Economic depreciation Economic income Economic rate of return Book depreciation Book income Book rate of return

Answer 1

	Year 1	Year 2	Year 3
Cash Flow	18.2	16.8	15.4
PV at start of the year	42	28	14
PV at End of Year	28	14	0
Change in PV	-14	-14	-14
Economic Depreciation	14	14	14
Economic Income	4.2	2.8	1.4
Economic Rate of return	10%	10%	10%
Book Depreciation	14	14	14
Book Income	4.2	2.8	1.4
Book Rate of return	10%	10%	10%
If the book rate of return is the same in each year of a project’s life, the book rate of return equals the IRR.
The present value of this asset at the start of the first year is the $42 million dollar investment. At the 10% cost of capital, the PV declines by $14 million per year. Thus, the economic income each year is 10% of this value. See the table above.
					NO projects true profitability is not book profitability