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?

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?

check_circleExpert Solution
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

$58000 x30%
PV of tax shield=
1.05
$17400
1.05
=S16571.4285714286
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$58000 x30% PV of tax shield= 1.05 $17400 1.05 =S16571.4285714286

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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...

PV of taxshiled-24360 [1-1+0.05)]/0.05
24360x[1-0.7835]/ 0.05
$105466.0517
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PV of taxshiled-24360 [1-1+0.05)]/0.05 24360x[1-0.7835]/ 0.05 $105466.0517

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