Question

Ms. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $704,000. Of this sum, $88,000 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 $88,000 straight-line over 5 years. The tax rate is 30% 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?

Answer 1

Solution a
	Installation cost	$ 88,000.00
	Tax rate	30%
	Tax benefit	$ 26,400.00	88000*30%
	This tax benefit will flow at the end of year 1
	PV factor @ 5% for year 1=	0.95238095
	PV of tax benefit=	26400*0.95238
	PV of tax benefit=	$ 25,142.86
	PV of cost=	88000-25142.86
	PV of cost=	$ 62,857.14
Solution b
	Installation cost	$ 88,000.00
	Annual depreciation	20%
	Annual depreciation	$ 17,600.00	88000*20%
	Tax benefit=	$    5,280.00	17600*30%
	Calculation of PV of cost		5%
	Year	Cash flow	PV factor, 1/(1+r)^time	Cashflow* PV factor
	0	$(88,000.00)	1.0000	$(88,000.00)
	1	$    5,280.00	0.9524	$    5,028.57
	2	$    5,280.00	0.9070	$    4,789.12
	3	$    5,280.00	0.8638	$    4,561.06
	4	$    5,280.00	0.8227	$    4,343.87
	5	$    5,280.00	0.7835	$    4,137.02
				$(65,140.36)
	So PV of this cost is $ 65,140.36