Question

In: Finance

Markov Manufacturing recently spent $ 13.7 million to purchase some equipment used in the manufacture of...

Markov Manufacturing recently spent $ 13.7 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five​ years, and its marginal corporate tax rate is 21 %. The company plans to use​ straight-line depreciation.

a. What is the annual depreciation expense associated with this​ equipment?

b. What is the annual depreciation tax​ shield?

c. Rather than​ straight-line depreciation, suppose Markov will use the MACRS depreciation method for the​ five-year life of the property. Calculate the depreciation tax shield each year for this equipment under this accelerated depreciation schedule.

d. If Markov has a choice between​ straight-line and MACRS depreciation​ schedules, and its marginal corporate tax rate is expected to remain​ constant, which schedule should it​ choose? Why?

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

f. Under the TCJA of​ 2017, Markov has the option to take​ 100% "Bonus" depreciation in the year in which the equipment is put into use. This means that in that​ year, Markov would take the full depreciation expense equivalent to the cost of buying the equipment. Rather than​ straight-line depreciation, suppose Markov will use the bonus depreciation method. Calculate the depreciation tax shield each year for this equipment with bonus depreciation.

g. If Markov has a choice between​ straight-line, MACRS and bonus depreciation​ schedules, and its marginal corporate tax rate is expected to remain​ constant, which schedule should it​ choose? Why?

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

Note​: Assume that the equipment is put into use in year 1.

Solutions

Expert Solution

a. Annual depreciation expenses = (Cost - salvage value) / no. of years of use = ($13.7 - 0) / 5 = $2.74mn

b. Annual depreciation tax shield = Depreciation expenses * marginal corporate tax rate = $2.74 * 21% = $575,400

c. Depreciation tax shield for each year in case of Depreciation as per MACRS schedule is calculated as follows:

Year 0 1 2 3 4 5 6
Depreciation Rate 20% 32% 19.20% 11.52% 11.52% 5.76%
Cost $13,700,000
Depreciation expenses (Cost during Year 0 * Depreciation rate) $2,740,000 $4,384,000 $2,630,400 $1,578,240 $1,578,240 $789,120
Tax rate 21% 21% 21% 21% 21% 21%
Depreciation tax shield (Depreciation expenses * tax rate) $575,400 $920,640 $552,384 $331,430 $331,430 $165,715

d. Depreciation as per straight line will be same for all the years. However as per MACRS schedule, Markov will be able to charge higher depreciation during the initial years owing to higher rates of depreciation during Year 2. Hence after following MACRS medthod, tax shields will be higher during initial years and hence present value of tax shields would be higher in case of MACRS schedule. Hence Markov should choose MACRS method of depreciation.

e. If marginal corporate tax rate will increase substantially over the next five​ years, then company will get benefit of higher tax shields in future years if it follows straight line depreciation method. The company may not get such benefit under MACRS schedule because the depreciation rate under it declines Year 3 onwards. Hence it is better to adopt straight line method of depreciation.       

f. If Markov takes benefit of 100% bonus depreciation as per TCJA 2017. Then the depreciation during the first year would be 100% of the cost i.e. $13.7mn. In such case the tax shields would be 21% of $13.7mn i.e. $2,877,000. However the companny will not get benefit of tax shields during subsequent years as it would have depreciated the asset fully. Hence total tax shields would be $2,877,000

g. If Markov has a choice between​ straight-line, MACRS and bonus depreciation​ schedules, and its marginal corporate tax rate is expected to remain​ constant, then it should choose bonus depreciation schedules because present value of tax shields would be maximum in such case owing to the entire amount of capex being claimed as depreciation during first year itself

h. Assuming that tax increases substantially over the next five years, it should choose straight line method as the present value of depreciation tax shields may exceed the one generated through bonus depreciation.

Happy Learning!


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