Question

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

Under MACRS method of 5 years the rate of depreciation
1st year	20%
2nd year	32%
3rd year	19.20%
4th year	11.52%
5th year	11.52%
6th year	5.76%

Answer 1

PV of cost of Kiln when installation cost is treated as a separate current expense

It is computed in excel sheet which is given below

Year	Depreciation	Normal tax savings@35%	PV@5%	Tax savings on PV	PV after tax savings	Year end and book value
0						350000
1	0.2	0.07	0.9524	0.066668	0.885732	310006.2
2	0.32	0.112	0.907	0.101584	0.805416	31491.67
3	0.192	0.0672	0.8638	0.0580474	0.805753	25374.5
4	0.1152	0.04032	0.8638	0.0348284	0.828972	21034.74
5	0.1152	0.04032	0.8638	0.0348284	0.828972	17437.2
6	0.0576	0.02016	0.8638	0.0174142	0.846386	14758.6

Working

Column 2 : From the MACRS depreciation chart of 5 years period the rate is taken

Column 3 : Normal tax savings is column 2 ˣ .35

Column 4: From the discounted rate chart of PV the rate is laid down

Column 5: Column 3 ˣ Column 4

Column 6: Column4 ‐ column 5

Column 7: Last book value ˣ next year column 6 rate

Answer 2

PV of cost of Kiln when installation cost is treated as a capital cost expense

Year	Depreciation	Normal tax savings@35%	PV@5%	Tax savings on PV	PV after tax savings	Year end and book value
0						400000
1	0.2	0.07	0.9524	0.066668	0.885732	354292.8
2	0.32	0.112	0.907	0.101584	0.805416	35990.48
3	0.192	0.0672	0.8638	0.0580474	0.805753	28999.42
4	0.1152	0.04032	0.8638	0.0348284	0.828972	24039.7
5	0.1152	0.04032	0.8638	0.0348284	0.828972	19928.23
6	0.0576	0.02016	0.8638	0.0174142	0.846386	16866.97

The previous working procedure to be followed