Question

On January 1, 2017, AmerEx Transportation Company purchased a used aircraft at a cost of $64,400,000. AmerEx expects the plane to remain useful for five years (7,000,000 miles) and to have a residual value of S6,400,000. AmerEx expects to fly the plane 775,000 miles the first year, 1,200,000 miles each year during the second, third, and fourth years, and 2.625,000 miles the last year. (Click the icon to view the first year depreciation amounts under each method.) Read the requirements. 1. Which depreciation method offers the highest tax advantage for the first year? Describe the nature of the tax advantage. The double-declining balance method offers the tax advantage for the first year of the asset's use. i Requirements The advantage results from the greater amount of depreciation (versus the other methods) in the first year. greater leaser Assume AmerEx is trying to decide which depreciation method to use for income tax purposes. The company can choose from among the following methods: (a) straight-line. (b) units-of-production, or (c) double-declining-balance methods. 1. Which depreciation method offers the highest tax advantage for the first year? Describe the nature of the tax advantage. 2. How much income tax will AmerEx save for the first year of the airplane's use under the method you just selected as compared with using the straight-line depreciation method? The company's income tax rate is 32%. Ignore any earnings from investing the extra cash. Print Done Click to select your answers) and then click Check Answer.

Answer 1

We will look into calculation of depreciation with each method one by one and then answer the questions.

Method 1 : Straight line method

Cost of aircraft = $64,400,000 Residual Value of aircraft = $64,00,000 Useful Life = 5 years

Depreciable Value = Cost of aircraft - Residual Value = $64.400,000 - $64,00,000 = $58,000,000

Depreciation for first year = Depreciable value / Useful life = $58,000,000 / 5 = $11,600,000

Method 2 : Units of production method

Cost of aircraft = $64,400,000 Residual Value of aircraft = $64,00,000 Miles expected over useful life = 7,000,000 miles

Depreciable Value = Cost of aircraft - Residual Value = $64.400,000 - $64,00,000 = $58,000,000

Depreciation for first year = (Depreciable value / Expected miles over useful life) x Expected miles in first year = ($58,000,000 / 7,000,000) x 775,000 = $6,421,429

Method 3 : Double declining method

Cost of aircraft = $64,400,000 Residual Value of aircraft = $64,00,000 Miles expected over useful life = 7,000,000 miles

Depreciable Value = Cost of aircraft - Residual Value = $64.400,000 - $64,00,000 = $58,000,000

Straight line depreciation % = (Straight line depreciation / Depreciable value) x 100 = (11,600,000 / 58,000,000) x 100 = 20%

Depreciation for first year = 2 x Straight line decpreciation % x Depreciable Value = 2 X 20% x 58,000,000 = $23,200,000

Summary

Method	Depreciation in first year
Straight line method	$11,600,000
Units of production method	$6,421,429
Double declining method	$23,200,000

Question 1) As you can see Double depreciation method makes the highest depreciation. Depreciation is an expense, and as expense increases profit decreases. Tax is calculated on profit. So lower profits make higher tax savings. Since we should increase expense to lower profit, choosing the method with highest depreciation will save more tax in first year. Thus Double declining method offers highest tax saving.

Question 2)

Tax savings = Depreciation in first year x tax rate

A.Tax savings straight line method = $11,600,000 x 32% = $3,712,000

B.Tax savings Double declining method = $23,200,000 x 32% = $7,424,000

C.Extra tax saved = A - B = $3,712,000