###### Interpret Cash Flow to the firm

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Amortization refers to the process of allocating the cost of an intangible asset over the asset’s useful life. Only the intangible assets which are assumed to have finite useful lives are amortized over their useful lives, along the lines by which the benefits are used up. Assets that are therefore assumed to have an indefinite useful life are not amortized.

Intangible assets with finite useful lives include an acquired customer list that is expected to provide benefits to a direct-mail marketing company for three to four years. Moreover, acquired patent or copyright with a specific expiration date, acquired license with a specific expiration date, and no right to renewal, fall in this category of assets. Lastly, an acquired trademark for a product that a company plans to phase out over a specific number of years is also an intangible asset with a finite useful life.

The calculation of amortization for an intangible asset requires knowledge of the original amount at which the intangible asset is recognized, estimates of the length of its useful life, and its residual value at the end of its useful life.

An asset’s useful life is estimated based on the expected use of the asset, considering legal, regulatory, contractual, competitive, or economic factors which may limit its life.

Similar to what obtains for the depreciation of tangible assets, there are three primary methods of amortization: the straight-line method, the accelerated method, and the units-of-production method.

Under the straight-line method of amortization, amortization expense is calculated as amortization cost divided by an asset’s estimated useful life and is the same for each period. In the accelerated method, the allocation of cost is greater in earlier years, while in the units-of-production method, the allocation of cost corresponds to the actual use of the asset in a particular period.

Question 1If an intangible asset costs $2,500, has an estimated salvage value of $50, and an estimated useful life of 4 years, what is the amortization expense under the straight-line method?

- $500.00
- $612.50
- $625.00

SolutionThe correct answer is

B.Under the straight-line method,

$$\text{Amortization expense} = \frac{(\$2,500 – \$50)}{4} = \$612.50.$$

Question 2Illicom Pharma acquired a license to produce a new drug for 3 million dollars. Under that license, the company has the right to produce unlimited units of the drug for the next five years. Should the company follow the double declining depreciation method to depreciate the asset, how much should the depreciation expense be in the last year?

- $388,800
- $423,050
- $600,000

SolutionThe correct answer is

A.The double declining depreciation method assumes applying double the depreciation rate applied in straight line depreciation. The straight line depreciation rate should be 1/5 = 20%, which makes the double declining depreciation rate 40% of the asset’s carrying amount at the beginning of the financial period. The table below illustrates how the calculations were done.

$$ \begin{array}{|c|c|c|c|}

\hline

{\textbf{Carrying value at} \\ \textbf{the beginning of} \\ \textbf{the period} } & {\textbf{Depreciation} \\ \textbf{expense rate} } & {\textbf{Depreciation} \\ \textbf{expense value} } & {\textbf{Carrying value at} \\ \textbf{the beginning of} \\ \textbf{the period} }\\\hline

{3,000,000} & {40\%} & {1,200,000} & {1,800,000} \\ \hline

{1,800,000} & {40\%} & {720,000} & {1,080,000} \\ \hline

{1,080,000} & {40\%} & {432,000} & {648,000} \\ \hline

{{648,000}} & {40\%} & {259,200} & {388,800} \\ \hline

{388,800} & { \text{The remaining value} \\ \text{of the asset}} & {388,800} & {0} \\ \hline

\end{array} $$