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 Services (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 kiln? The tax rate is 35 percent and the opportunity cost of capital is 5 percent.
If the $50,000 is expensed at the end of year 1, the value of the tax shield is: If the $50,000 expenditure is capitalized and then depreciated using a five-year MACRS depreciation schedule, the value of the tax shield is:
If the cost can be expensed, then the tax shield is larger, so that the after-tax cost is smaller. …show more content…
Company A has substantial accumulated tax losses and is unlikely to pay taxes n the foreseeable future. Company B pays corporate taxes at a rate of 35 percent and can deprecate the investment for tax purposes using the five- year MARCS tax deprecation schedule. Suppose the opportunity cost of capital is 8 percent. a. Calculate project NVP for each company. b. What is the IRR of the after-tax cash flows for each company? What does comparison of the IRRs suggest is the effective corporate tax