Question

Spherical Manufacturing recently spent $ 10 million to purchase some equipment used in the manufacture of disk drives. This equipment has a CCA rate of 25 % and​ Spherical's marginal corporate tax rate is 28 %

a. What are the annual CCA deductions associated with this equipment for the first five​ years?

b. What are the annual CCA tax shields for the first five​ years?

c. What is the present value of the first five CCA tax shields if the appropriate discount rate is 12 % per​ year?

d. What is the present value of all the CCA tax shields assuming the equipment is never sold and the appropriate discount rate is 12 % per​ year?

e. How might your answer to part​ (d) change if Spherical anticipates that its marginal corporate tax rate will increase substantially over the next five​ years?

Answer 1

a) Annual CCA deductions associated with the equipment for the first five years:

CCA deductions = opening book value * CCA rate

  

Year	Opening Book value	CCA deductions	Closing book value
1	$10,000,000	$2,500,000	$7,500,000
2	$7,500,000	$1,875,000	$5,625,000
3	$5,625,000	$1,406,250	$4,218,750
4	$4,218,750	$1,054,688	$3,164,062
5	$3,164,062	$791,016	$2,373,046

b) Annual CCA tax shield

Year	CCA Deductions	Tax Shiels @28%
1	$2,500,000	$700,000
2	$1,875,000	$525,000
3	$1,406,250	$393,750
4	$1,054,688	$295,313
5	$791,016	$221,484

c) PV of CCA tax shields:

Year	CCA Deductions	Tax Shields @28%	Discount factor @12%	Present value
1	$2,500,000	$700,000	0.893	$625,100
2	$1,875,000	$525,000	0.797	$418,425
3	$1,406,250	$393,750	0.712	$280,350
4	$1,054,688	$295,313	0.636	$187,819
5	$791,016	$221,484	0.567	$125,581

d)PV of CCA tax shields till perpetuity:

PV=( ( equipment cost * tax rate *CCA rate* ( 1 rate of return / 2) ) /[ Rate of return + CCA rate ) *( 1 +rate of return)]

= ( $10,000,000 * 28% * 25% * ( 1 + 0.12/2)] / [ 0.12+0.25] * [ 1+0.12] .37

=$742,000 / 0.4144

= $1,790,540