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 company will need 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 straight-line over five years.

How will the tax authority's decision affect the after-tax cost of the kiln? The tax rate is 25%, and the opportunity cost of capital is 5%. (Do not round intermediate calculations. Round your answers to the nearest whole dollar amount.)

Unsure how to get the answer to the second part of the question.

Answer 1

If the $50,000 is expenses at the end of year 1 then present value of tax shield = 0.25*50,000/1.05

= $11,904.76. This can be rounded off to $11,905

If instead the $50,000 amount is capitalized then the depreciation using a straight line will give the following value of tax shield:

Annual depreciation = 50,000/5 = 10,000

Year	Annual depreciation	PV = depreciation * 1/1.05^n	Tax shield = 25% of PV
1	10,000.00	9,523.81	2,380.95
2	10,000.00	9,070.29	2,267.57
3	10,000.00	8,638.38	2,159.59
4	10,000.00	8,227.02	2,056.76
5	10,000.00	7,835.26	1,958.82
		Total	10,823.69

This can be rounded off to $10,824.

So if the cost can be expensed then the tax shield is larger and hence the after-tax cost of kiln will be lower.