Warning Industries is considering two alternative ways to depreciate a proposed investment.The investment has an initial cost of $100,000 and an expected five-year life.The two alternative depreciation schedules follow:
$\begin{array}{llc}
&\underline{\text { Method 1 }}&\underline{\text { Method2}} \
\text { Year } 1 \text { depreciation } & \$20,000&\$40,000 \
\text { Year 2 depreciation } & \$ 20,000 & \$ 30,000 \
\text { Year 3 depreciation } & \$ 20,000 & \$ 20,000 \
\text { Year 4 depreciation } & \$ 20,000 & \$ 10,000 \
\text { Year 5 depreciation } & \$ 20,000 & \$ 0
\end{array}$

Assuming that the company faces a marginal tax rate of 40 percent and has a cost of capital of 10 percent,what is the difference between the two methods in the present value of the depreciation tax benefit? Present value tables or a financial calculator are required.

Question

Warning Industries is considering two alternative ways to depreciate a proposed investment.The investment has an initial cost of $100,000 and an expected five-year life.The two alternative depreciation schedules follow:
$\begin{array}{llc}
&\underline{\text { Method 1 }}&\underline{\text { Method2}}  \
\text { Year } 1 \text { depreciation } & \$20,000&\$40,000 \
\text { Year 2 depreciation } & \$ 20,000 & \$ 30,000 \
\text { Year 3 depreciation } & \$ 20,000 & \$ 20,000 \
\text { Year 4 depreciation } & \$ 20,000 & \$ 10,000 \
\text { Year 5 depreciation } & \$ 20,000 & \$ 0
\end{array}$

Assuming that the company faces a marginal tax rate of 40 percent and has a cost of capital of 10 percent,what is the difference between the two methods in the present value of the depreciation tax benefit? Present value tables or a financial calculator are required.

Quizplus · Accepted Answer

The difference in the present value of the depreciation tax benefit between the two methods is calculated by finding the present value of the depreciation expenses for each year under both methods, multiplying them by the tax rate to find the tax shield, and then subtracting the present values of the tax shields under Method 2 from those under Method 1. Since Method 2 accelerates depreciation, it provides a higher tax shield in the earlier years, which has a higher present value due to the time value of money. The exact difference requires calculating the present value of each year's depreciation tax shield for both methods and then comparing them.

Warning Industries Is Considering Two Alternative Ways to Depreciate a Proposed