Reye Corporation has provided the following information concerning a capital budgeting project: The company's income tax rate is 30% and its after-tax discount rate is 9%. The working capital would be required immediately and would be released for use elsewhere at the end of the project. The company uses straight-line depreciation on all equipment. Assume cash flows occur at the end of the year except for the initial investments. The company takes income taxes into account in its capital budgeting.The income tax expense in year 2 is:
A) $129,000
B) $15,000
C) $18,000
D) $96,000

Question

Reye Corporation has provided the following information concerning a capital budgeting project:  The company's income tax rate is 30% and its after-tax discount rate is 9%. The working capital would be required immediately and would be released for use elsewhere at the end of the project. The company uses straight-line depreciation on all equipment. Assume cash flows occur at the end of the year except for the initial investments. The company takes income taxes into account in its capital budgeting.The income tax expense in year 2 is:
A) $129,000 
B) $15,000 
C) $18,000 
D) $96,000

Quizplus · Accepted Answer

To calculate the income tax expense in year 2, we need to first calculate the taxable income in year 2 which is given by:
Taxable income in year 2 = Earnings Before Taxes - Depreciation - Interest Expense
= $450,000 - $150,000/3 - $225,000
= $300,000 - $50,000 - $225,000
= $25,000

Now, we can calculate the income tax expense in year 2 as follows:
Income tax expense in year 2 = Taxable income in year 2 x Income tax rate
= $25,000 x 30%
= $7,500

However, we also need to take into account the tax shield effect of depreciation. Since the equipment is being depreciated over 3 years, the depreciation expense in year 2 would be $150,000/3 = $50,000. This depreciation expense reduces the taxable income in year 2 and thus reduces the income tax expense. The tax shield effect of depreciation is given by:
Tax shield effect of depreciation = Depreciation expense in year 2 x Income tax rate
= $50,000 x 30%
= $15,000

Therefore, the total income tax expense in year 2 is:
Total income tax expense in year 2 = Income tax expense in year 2 - Tax shield effect of depreciation
= $7,500 - $15,000
= -$7,500

Since the tax shield effect of depreciation is greater than the income tax expense in year 2, the company would actually receive a tax credit of $7,500 in year 2 which would reduce its overall tax liability. Therefore, the correct answer is C.

Reye Corporation Has Provided the Following Information Concerning a Capital