Your firm needs a machine which costs $20,000, and requires $1,000 in maintenance for each year of its three-year life. After three years, this machine will be replaced. The machine falls into the MACRS three-year class life category. Assume a tax rate of 40 percent and a discount rate of 9 percent. What is the depreciation tax shield for this project in year 3?

Question

Quizplus · Accepted Answer

The MACRS three-year class life category means that the depreciation will be deducted for 33.33% in year 1, 44.45% in year 2, 14.81% in year 3, and 7.41% in year 4 (note that the fourth year is included for the purpose of the calculation, even though there will be no machine in that year).

So, in year 3, the depreciation deduction will be $20,000 x 14.81% = $2,962.

The depreciation tax shield is the tax savings due to the depreciation deduction, which is calculated as the depreciation deduction multiplied by the tax rate.

Therefore, the depreciation tax shield in year 3 is $2,962 x 40% = $1,184.80.

Option A is the correct choice.

Your Firm Needs a Machine Which Costs $20,000, and Requires