A microprocessor company just bought an asset for $88,000, and they plan to keep

Question

A microprocessor company just bought an asset for $88,000, and they plan to keep it for a full 10 years. For tax purposes the company is allowed two depreciation options. Option 1: The Alternative Depreciation System (ADS) that allows for a 5 year straight line (SL) depreciation with the half life convention. Option II: The General Depreciation System (GDS) that allows for a 5 year MACRS depreciation. The current investment rate is 10% per year, and the Tax Rate is 52%. The anticipated cash flow before taxes (CFBT) is $25,000 for each of the 10 years of the assets life. Which tax depreciation option will minimize the Present Worth of the Tax amounts over the fulI life of the asset.

Explanation / Answer

Option : Straight Line with half life convention

Depreciation Expenses in Year 1 = 88000*1/5*1/2 = 17600 = 8800

Depreciation Expenses in Year 2 = 88000*1/5 = 17600

Depreciation Expenses in Year 3 = 88000*1/5 = 17600

Depreciation Expenses in Year 4 = 88000*1/5 = 17600

Depreciation Expenses in Year 5 = 88000*1/5 = 17600

Depreciation Expenses in Year 6 = 88000*1/5*1/2 = 8800

Depreciation Tax Shield in Year 1 = 8800*52% = 4576

Depreciation Tax Shield in Year 2 = 17600*52% = 9152

Depreciation Tax Shield in Year 3 = 17600*52% = 9152

Depreciation Tax Shield in Year 4 = 17600*52% = 9152

Depreciation Tax Shield in Year 5 = 17600*52% = 9152

Depreciation Tax Shield in Year 6 = 8800*52% = 4576

Present Worth of Depreciation Tax Shield = 4576/1.10 + 9152/1.1^2 + 9152/1.1^3 + 9152/1.1^4 + 9152/1.1^5 + 4576/1.1^6

Present Worth of Depreciation Tax Shield = $ 33,116.31

Option : General Depreciation System (GDS) MACRS Depreciation

Depreciation Expenses in Year 1 = 88000*20% = 17600

Depreciation Expenses in Year 2 = 88000*32% = 28160

Depreciation Expenses in Year 3 = 88000*19.20% = 16896

Depreciation Expenses in Year 4 = 88000*11.52% = 10137.60

Depreciation Expenses in Year 5 = 88000*11.52% = 10137.60

Depreciation Expenses in Year 6 = 88000*5.76% = 5068.80

Depreciation Tax Shield in Year 1 = 17600*52% = 9152

Depreciation Tax Shield in Year 2 = 28160*52% = $ 14,643.20

Depreciation Tax Shield in Year 3 = 16896*52% = $ 8785.92

Depreciation Tax Shield in Year 4 = 10137.6*52% = $ 5271.55

Depreciation Tax Shield in Year 5 = 10137.6*52% = $ 5271.55

Depreciation Tax Shield in Year 6 = 5068.80*52% = $ 2635.78

Present Worth of Depreciation Tax Shield = 9152/1.10 + 14643.20/1.1^2 + 8785.92/1.1^3 + 5271.55/1.1^4 + 5271.55/1.1^5 + 2635.78/1.1^6

Present Worth of Depreciation Tax Shield = $ 35,384.40

Which tax depreciation option will minimize present worth of the Tax amounts over full life of assets?

Answer

General Depreciation System (GDS) MACRS Depreciation Option will minimize present worth of the Tax amounts over full life of assets as its Present Worth of Depreciation Tax Shield is higher than ADS Straight Line Depreciation

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