Question

Ms. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $470,000. Of this sum, $57,000 is described by the supplier as an installation cost. Ms. Potts does not know whether the Internal Revenue Service (IRS) will permit the company to treat this cost as a tax-deductible first-year expense or as a capital investment. In the latter case, the company could depreciate the $57,000 using the five-year MACRS tax depreciation schedule. Assume the tax rate is 34% and the opportunity cost of capital is 7%. Calculate the value of the tax shield 1 and tax shield 2. (Note: Use Tax shield 1 as an expense treatment and tax shield 2 as 5 year MACRS.) (Do not round intermediate calculations. Round your answers to the nearest dollar amount.)

Answer 1

Tax Shield 1 saves Ideal China $19,380 in the first year as an immediate expense. Tax Shield 2 requires calculating the present value of tax savings from depreciation over five years using the MACRS schedule and the company's tax rate, discounted at the opportunity cost of capital.

Step-by-step explanation:

When analyzing whether the installation cost is an expense or a capital investment, the tax implications differ. As an expense under Tax Shield 1, the $57,000 would be deducted from taxable income in the first year, saving Ideal China $19,380 (34% of $57,000). If treated as a capital investment under Tax Shield 2 and depreciated using the five-year MACRS schedule, the value of the tax shield depends on the depreciation deduction for each year multiplied by the tax rate.

The tax shield in this case is the present value of the depreciation deductions multiplied by the tax rate, discounted back at the opportunity cost of capital (7%). However, the specific calculation of the tax shield for the five-year MACRS schedule requires additional information about the depreciation percentages for each year.