Bailey Corporation is considering modernizing its production by purchasing a new

Question

Bailey Corporation is considering modernizing its production by purchasing a new machine and selling an old machine. The following data have been collected on this investment: Old Machine New Machine Cost $40,000 Cost $19,000 Accumulated depreciation $20,000 Estimated useful life 4 years Remaining life 4 years Salvage value in 4 years $5,000 Current salvage value $5,000 Annual cash operating costs $14,000 Salvage value in 4 years $-0- Annual cash operating costs $18,000 The income tax rate is 40%, and the required rate of return is 16%. Depreciation is $5,000 per year for the old machine. The new machine would be depreciated $7,600 in 20x1, $5,700 in 20x2, $3,800 in 20x3, and $1,900 in 20x4. Assume Bailey would purchase the new machine in December 20x0 and dispose of the old machine in January 20x1. 34. Bailey’s 20x0 depreciation tax shield for the old machine is a. $5,000 b. $4,000 c. $3,000 d. $2,000 I am not sure if what I am doing it right, but the way I do it is: Take current book value: 20,000 / 4 = 5000, then multiply by (1-taxrate) (.6) to get = 3,000 (C) Am i doing this correct? also can you explain the detail of what a tax shield? Thanks!

Explanation / Answer

Tax Shield - A tax shield is the reduction of income taxes that results from taking and allowable deduction from Income Tax. The tax shield is to defer or eliminate a tax liability. Examples of taxable expenses used as a tax shield are: 1. Taking Loan, in order to charge off the interest expense on loan as a taxable expense 2. Acquiring fixed assets like machines, equipments, etc., to charge depreciation as a taxable expense. The value of a tax shield is calculated as the amount of the taxable expense, multiplied by the tax rate. Depreciation Tax Shield = $5000 (Dep. On old Machine) X 40% (Tax rate) = $2000 Correct Answer d. $2000

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