P2 (30 points): Your company recently purchased two large pieces of production e
ID: 2400439 • Letter: P
Question
P2 (30 points): Your company recently purchased two large pieces of production equipment for $125,000 each. One piece of equipment was installed at your firm's Texas facility and is being depreciated by MACRS depreciation. The other piece of equipment was placed in the California facility, where it is being depreciated by sum-of-years'- digits depreciation with zero salvage value. Assume the company pays federal income taxes each year and the tax rate is constant. Your corporate accounting department noted that the two pieces of equipment are being depreciated differently and wonders whether the corporation will wind up paying more income taxes over the life of the equipment as a result of this What do vou tell them? P3 (40 points): A marketing product company (i.e, the kind that makes small free-bees with your company's name on it to give away at trade shows and on college campuses) can either buy customized drink coasters at 5 cents each or install $500,000 worth of production equipment and manufacture the coasters at their plant. The manufacturing engineer estimates the material, labor, and other costs would be 3 cents per coaster (a) If 12 million customized coasters per year are needed and the equipment is installed, what is the payback period? (b) The production equipment would be depreciated by sum-of-the-year-digits tion using a 5-year useful life and no salvage deprecia value. Assuming a combined 40% income tax rate, what is the after-tax payback period, and what is the after-tax rate of return:Explanation / Answer
The total depreciation during the useful life of the production equipment will be equal to the depreciable asset value ($125,000), whether we use MACRS depreciation or Sum of digit method.
Hence the total depreciation tax shield will be same over the life of the equipment .
Total Depreciation tax shield=Sum of (Depreciation amount * Tax Rate)
The total income tax paid over the life of equipment will be same for both the equipment.
Assume Useful Life=6 Years
Income Tax Rate=35%
MACRS 5 year depreciation:
N
A
B=A*125000
C=B*0.35
Year
MACRS rate
Depreciation
Tax Shield
1
20%
$ 25,000
$ 8,750
2
32%
$ 40,000
$ 14,000
3
19.20%
$ 24,000
$ 8,400
4
11.52%
$ 14,400
$ 5,040
5
11.52%
$ 14,400
$ 5,040
6
5.76%
$ 7,200
$ 2,520
Total
$ 125,000
$ 43,750
SUM OF DIGITS DEPRECIATION
Sum of Digits=1+2+3+4+5+6=21
Depreciation in year 1=(6/21)*125000,Year2=(5/21)*125000, Year3=(4/21)*125000,year4=(3/21)*125000, year5=(2/21)*125000, Year6=(1/21)*125000
N
A
B=A*125000
C=B*0.35
Year
Sum of digit rate
Depreciation
Tax Shield
1
0.29
$ 35,714
$ 12,500
2
0.24
$ 29,762
$ 10,417
3
0.19
$ 23,810
$ 8,333
4
0.14
$ 17,857
$ 6,250
5
0.10
$ 11,905
$ 4,167
6
0.05
$ 5,952
$ 2,083
Total
$ 125,000
$ 43,750
Total Tax over the life of the equipment will be the same
N
A
B=A*125000
C=B*0.35
Year
MACRS rate
Depreciation
Tax Shield
1
20%
$ 25,000
$ 8,750
2
32%
$ 40,000
$ 14,000
3
19.20%
$ 24,000
$ 8,400
4
11.52%
$ 14,400
$ 5,040
5
11.52%
$ 14,400
$ 5,040
6
5.76%
$ 7,200
$ 2,520
Total
$ 125,000
$ 43,750
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