Question

Markov Manufacturing recently spent $16.7 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? (Round to three decimal places)

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

Straight Line Depriciation Method

a) Depriciation = (Cost - Salvage Value) / Years

Depriciation = (16.7 - 0) / 5

Depriciation = 16.7 / 5

Depriciation =  $3.34 million

b) Annual Depriciation Tax Shield = 3.34 * 21% (Depriciation * Tax rate)

Annual Depriciation Tax Shield = $0.701 million

(Note* A depreciation tax shield is a tax reduction technique under which depreciation expense is subtracted from taxable income. The amount by which depreciation shields the taxpayer from income taxes is the applicable tax rate, multiplied by the amount of depreciation.)

c) MACRS Depriciation

1st Year Depriciation = Cost * 1/5 * 200%(Declining Balance Method) * 1/2(for half year convention)

1st year Depriciation = 16.7 * 1/5 * 200% * 1/2

1st Year Depriciation = 16.7 * 0.40 * 1/2

1st Year Depriciation = 3.34

2nd Year Depriciation = (16.7 - 3.34) * 1/5 * 200%

2nd Year Depriciation = 5.344

3rd year Depriciation = (16.7- 3.34 - 5.344) * 1/5 * 200%

3rd Year = 3.206

3rd Year Deprication = (16.7 - 3.34 - 5.344) * 1/2.5

3rd Year Deprication = 3.206

{Note * (MACRS declining balance changes to straight-line method when that method provides an equal or greater deduction.)

Declining Balance = (16.7- 3.34 - 5.344) * 1/5 * 200%

Declining Balance = 3.206}

4th Year Depriciation = (16.7 - 3.34 - 5.344 - 3.206) * 1/1.5

4th Year Depriciation = 3.206

5th Year Depriciation = 3.206 * 0.5

5th Year Depriciation = 1.604

d) Initially it should choose MACRS Declining balance method of depriciation and it should be converted to SLM depriciation method when that method (SLM) provides equal or greater value. As from that point SLM method will provide higher tax shield value