Question

Your company is considering a new project that will require $100,000 of new equipment at the start of the project. The equipment will have a depreciable life of 10 years and will be depreciated to a book value of $25,000 using straight-line depreciation. The cost of capital is 11 percent, and the firm's tax rate is 34 percent. Estimate the present value of the tax benefits from depreciation.

Answer 1

Depreciation per year as per straight line method

= ( Purchase cost – Salvage value ) / Useful life

= ( $100,000 - $25,000) / 10

= $7,500 each year

Depreciation tax saving

= Depreciation x Tax rate

= $7,500 x 34%

= $ 2,550

Present value of depreciation tax saving

Since saving each year is same, we can use annuity factor to calculate the present value of tax saving

Annuity factor

= [ 1 – ( 1 + r) ^ -n] / r

Where,

r = Rate of interest = 11% or 0.11

n = Number of years = 10

So, Annuity factor

= [ 1 – ( 1.11 ^ -10)] / 0.11

= [ 1 - 0.352184] / 0.11

= 5.889232

So, Present value of depreciation tax savings

= Saving each year x Annuity factor

= $2,550 x 5.889232

= $ 15,017.54