Question

Ms. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $528,000. Of this sum, $66,000 is described by the supplier as an installation cost. Ms. Potts does not know whether the Internal Revenue Service (IRS) will permit the company to treat this cost as a tax-deductible current expense or as a capital investment. In the latter case, the company could depreciate the $66,000 straight-line over 5 years. The tax rate is 30% and the opportunity cost of capital is 5%.

a. What is the present value of the cost of the kiln if the installation cost is treated as a separate current expense?

b. What is the present value of the cost of the kiln if the installation cost is treated as a part of the capital investment?

Answer 1

Depreciation = cost of asset / 5

Year Depreciation Tax shield Depreciation minus Tax Shield Discount Factor O nM+in 92,400 27,720 64,680 92,400 27,720 64,680 92,400 27,720 64,680 92,400 27,720 64,680 92,400 27,720 64,680 Present value of cost of kiln 0.9524 0.9070 0.8638 0.8227 0.7835 Present value of cost 66,000.00 <<-- Installation Cost 61,600.00 58,666.67 55,873.02 53,212.40 50,678.47 346,030.55 Year Discount Facto U AWNA Depreciation Depreciation Tax shield minus Tax Shield 105,600 31,680 73,920 105,600 31,680 73,920 105,600 31,680 73,920 105,600 31,680 73,920 105,600 31,680 73,920 Present value of cost of kiln 0.9524 0.9070 0.8638 0.8227 0.7835 Present value of cost 70,400.00 67,047.62 63,854.88 60,814.17 57,918.25 320,034.92

Tax Shield = Depreciation * Tax Rate

Tax shield is the saving in tax due to depreciation

Discount Factor formula:

Discount Factor = 7 (1 + i)"

Where,
i = rate of return
n = number of periods