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

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

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