Question

Markov Manufacturing recently spent $11.5 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? a. What is the annual depreciation expense associated with this equipment? The annual depreciation expense is $ million. (Round to three decimal places.) b. What is the annual depreciation tax shield? The annual depreciation tax shield is $ million. (Round to three decimal places.) 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. The depreciation tax shield for year 1 is $ million. (Round to three decimal places.) The depreciation tax shield for year 2 is $ million. (Round to three decimal places.)

Answer 1

a]

annual depreciation = cost of equipment / useful life

annual depreciation = $11.5 million / 5 = $2.300 million

b]

annual depreciation tax shield = annual depreciation * tax rate

annual depreciation tax shield = $2.300 million * 21% = $0.483 million

c]

A B MACRS Depreciation Depreciation 1 year Rate Depreciation tax shield 1 20.00% $ 2,300,000 $ 483,000 2 32.00% $ 3,680,000 $ 772,800 3 19.20% $ 2,208,000 $ 463,680 11.52% $ 1,324,800 $ 278,208 11.52% $ 1,324,800 $ 278,208 5

1 year 2 1 B MACRS Depreciation Rate 0.2 0.32 0.192 0.1152 0.1152 3 4 2 3 Depreciation =11500000*B2 =11500000*B3 =11500000*B4 =11500000*B5 =11500000*B6 Depreciation tax shield =C2*21% =C3*21% =C4*21% =C5*21% =C6*21%

d]

It should choose MACRS schedule because the depreciation tax shield is higher in the earlier years. This results in a higher cash flow in the earlier years, and thereby a higher present value of the cash flows