Question

Markov Manufacturing recently spent

$ 13.6 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.

Answer 1

Solution:

Markov Manufacturing
Cost of Equipment	13600000
Useful Life	5
Marginal Corporate Tax	21%
Straight Line Depreciation	=13.6/5
	2720000

Annual Depreciation	2720000
Tax Sheild (2.72 *21%)	571200
Tax Sheild over the years	2856000

Cost of Equipment	13600000						Total
Depreciation Rate (MACRS)	20%	32%	19.20%	11.52%	11.52%	5.76%	100%
	2720000	4352000	2611200	1566720	1566720	783360	13600000
Tax Rate	21%	21%	21%	21%	21%	21%
Tax Sheild	571200	913920	548352	329011.2	329011.2	164505.6	2856000

d. The total tax sheild under both the methods are the same. But with MACRS Depreciation Markovo receives the tax depreciation sooner,. Therefore MACRS Depreciation will lead to a higher NPV of Markovos Cash Flows.

e.If the tax rate increases, then it may be better off claiming higher depreciation expenses in later years, as the tax benefit at that time will be greater.