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ABC Products needs to replace its rawhide tanning and molding equipment. It can be used for...

ABC Products needs to replace its rawhide tanning and molding equipment. It can be used for five years and will have no salvage value. The equipment costs $930,000. The firm can lease it for $245,000 a year, or it can borrow the money to purchase the equipment at 7%. The firm's tax rate is 34%. The CCA rate is 20% (Class 8).What is the present value of the depreciation tax shield? Select one: a. $277,177 b. $26,876 c. $251,193 d. $243,885 e. $236,959

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Expert Solution

Answer is D: $243,885 (difference between this amount and caln below is due to rounding off difference

Given
Asset Value 930000.00
Salvage Value 0
Depreciable Life (Years) 5
Depn Rate 20%
Tax Rate 34%
Discount Rate (Cost of Capital to Company for Borrowing) 7%
We need to find the PV of the Tax Shield we get on Depreciation
Tax Shield on Depn = (Depn Amount p.a. * Tax Rate)
Pv of Tax Shield on Depn = Tax Shield on Depn / [(1 + Discount Rate)^N]
Annual Depn [(930,000-0)/5] 186000
Annual Tax Shield on Depn (186000*34%) 63240
Every year we save 63,240 due to Depn, now we need to discount it back for 5 years

Please note, that Depn Exp in the first year results in a tax shield in the following year. So we start taking Tax shield from Year 2:

Year 1 2 3 4 5 6
PVF @ 7% 0.9346 0.8734 0.8163 0.7629 0.7130 0.6663
Tax Shield 63240 63240 63240 63240 63240 63240
PV of Tax Shield - 55,236 51,623 48,245 45,089 42,139
Total PV of Tax Shield $242,333

jeff jeffy answered 1 year ago
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