Question

Problem 9-24 Depreciation and Project Value (LO3)

Ms. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $400,000. Of this sum, $50,000 is described by the supplier as an installation cost. Ms. Potts does not know whether the Internal Revenue Service (IRS) will permit the company to treat this cost as a tax-deductible current expense or as a capital investment. In the latter case, the company could depreciate the $50,000 using the five-year MACRS tax depreciation schedule. The tax rate is 35% and the opportunity cost of capital is 5%.

a. What is the present value of the cost of the kiln if the installation cost is treated as a separate current expense?

b. What is the present value of the cost of the kiln if the installation cost is treated as a part of the capital investment? (Round your answers to the nearest whole dollar amount.)

Answer 1

a)	PV of tax shield if installation cost is treated separately = 50000*35%/1.05 =	$         16,667
	PV of tax shield on cost of kiln alone:
	Year	Depreciation %	Depreciation	Tax shield on depreciation	PVIF at 5%	PV of DTS
	1	20.00	$        70,000	$        24,500	0.95238	$          23,333
	2	32.00	$    1,12,000	$        39,200	0.90703	$          35,556
	3	19.20	$        67,200	$        23,520	0.86384	$          20,317
	4	11.52	$        40,320	$        14,112	0.82270	$          11,610
	5	11.52	$        40,320	$        14,112	0.78353	$          11,057
	6	5.76	$        20,160	$          7,056	0.74622	$            5,265
	Total	100.00	$    3,50,000	$    1,22,500		$      1,07,139
	Total PV of depreciation tax shields = 16667+107139 =	$     1,23,806
	PV of cost of kiln = 400000-123806 =	$     2,76,194
b)	PV of tax shield on cost of kiln+installation cost:
	Year	Depreciation %	Depreciation	Tax shield on depreciation	PVIF at 5%	PV of DTS
	1	20.00	$        80,000	$        28,000	0.95238	$          26,667
	2	32.00	$    1,28,000	$        44,800	0.90703	$          40,635
	3	19.20	$        76,800	$        26,880	0.86384	$          23,220
	4	11.52	$        46,080	$        16,128	0.82270	$          13,269
	5	11.52	$        46,080	$        16,128	0.78353	$          12,637
	6	5.76	$        23,040	$          8,064	0.74622	$            6,017
	Total	100.00	$    4,00,000	$    1,40,000		$      1,22,444
	PV of cost of kiln = 400000-122444 =	$     2,77,556
c)	Method at [a] would be preferred as it has higher PV of tax shields.