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IvanRivera6.Unit4-MT480-Project - Ivan Rivera6 MT480...

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Ivan Rivera6 MT480 – Corporate Finance Project Chapter 6 Chapter 6 4. Mrs. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $400,000. Of this sum, $50,000 is described by the supplier as an installation cost. Mrs. 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 $50,000 using the five year MACRS tax depreciation schedule. How will the IRS’s decision affect the after-tax cost of the kiln? The tax rate is 35 percent and the opportunity cost of capital is 5 percent. Case 1: Tax deductible current expense After-tax cost (of installation cost) = $50,000 – (1 - .35) $32,500 PV of tax shield = (50,000 x 35%)/1.05 16,666.67 Case 2: Capital Investment Year MACRS Depreciation Tax shield PV of tax dep. Rate expense shield 1 20% 10000 3500 3333.33 2 32% 16000 5600 5079.37 3 19.20% 9600 3360 2902.49 4 11.52% 5760 2016 1658.57 5 11.52% 5760 2016 1579.59 6 5.76% 2880 1008 752.19 PV of tax shield = 15305.53
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The present value of tax shield is higher if the installation costs can be expensed in the current period. Thus, the after-tax cost of kiln will be lower if the installation costs are expensed entirely in the current period. The net benefit by expensing it would be 16,666.67 - $15,305.53 $1,361.14 and so the after-tax cost of the kiln would be lower by the
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