Suppose a corporation can change its depreciation method so that its tax payment

Question

Suppose a corporation can change its depreciation method so that its tax payments
will decrease by $1,000 this year but increase by $1,000 next year.
a. The change will decrease the value of the company because lower tax payments this
year result from iower reoorted income.
b. The change will increase the value of the company because the value of the cash sav-
ings this year exceeds the cost of the cash payments next year.
c. The change will have no impact on the value of the company because its cash flow
over time will be the same.
d. The change will decrease the value of the company because investors don't like
changes in accounting methods.

Explanation / Answer

b. The change will increase the value of the company because the value of the cash savings this year exceeds the cost of the cash payments next year. Reason: A dollar saved today is worth more than the same dollar saved tomorrow. Because of changing the depreciation method, the company is able to save $1000 today. The increase by $1000 tax for the next year is not worth the same $1000 when discounted to the present value, the time value being considered. For example, if the company’s cost of capital is 10%, the $1000 payable 1 year from now, is worth only $909.09 in present value terms ($1000/(1+.10)). The company is therefore saving $1000 now for actually spending $909.09, the net savings being $90.91. This savings will ultimately increase the value of the company because the value of the cash savings this year exceeds the cost of the cash payments next year.

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