Question

Asked Nov 8, 2019

Ms. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $464,000. Of this sum, $58,000 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 current expense or as a capital investment. In the latter case, the company could depreciate the $58,000 straight-line over 5 years. The tax rate is 30% and the opportunity cost of capital is 5%.

**a. **What is the present value of the cost of the kiln if the installation cost is treated as a separate current expense?**b. **What is the present value of the cost of the kiln if the installation cost is treated as a part of the capital investment?

Step 1

When the installation cost is treated as a separate current expense, then the present value of the tax shield on installation cost can be calculated as below

Step 2

Present Value of the remaining cost can be calculated as $406000 (464000-58000).

Depreciation on straightline is $81200 ($406000/4)

Tax shield on this is 30%*$81200 =$24360

Step 3

Present Value fo...

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