The Morgan Company has been awarded a six-year contract to provide repair service to a commercial bus line. Morgan Company has gathered the following data associated with the items needed for this contract:

The special equipment is in Class 7 with a maximum 15% CCA rate. The income tax rate is 40%, and Morgan's after-tax cost of capital is 14%. At the end of six years, the working capital will be released for use elsewhere.

-Assume the special equipment will have a zero salvage value (instead of $20,000)at the end of six years.The present value of the total tax savings for all years because of the CCA tax shield is closest to which of the following?

Question

The Morgan Company has been awarded a six-year contract to provide repair service to a commercial bus line. Morgan Company has gathered the following data associated with the items needed for this contract:

The special equipment is in Class 7 with a maximum 15% CCA rate. The income tax rate is 40%, and Morgan's after-tax cost of capital is 14%. At the end of six years, the working capital will be released for use elsewhere.

-Assume the special equipment will have a zero salvage value (instead of $20,000)at the end of six years.The present value of the total tax savings for all years because of the CCA tax shield is closest to which of the following?

Quizplus · Accepted Answer

To find the present value of the total tax savings for all years because of the CCA tax shield, we need to calculate the annual tax savings and then find the present value of those savings.

The annual tax savings due to CCA tax shield = (15% CCA rate) x (cost of the equipment) x (income tax rate)
= 0.15 x 450,000 x 0.4
= $27,000

To find the present value of these annual tax savings, we can use the formula:
PV = (annual tax savings) x (PVIFA k%, n)

Where k% is the after-tax cost of capital, n is the number of years (6), and PVIFA is the present value interest factor for an annuity.

Using a financial calculator or spreadsheet, we can find that the PVIFA for 14% and 6 years is 4.9676.

So, PV = $27,000 x 4.9676
= $134,203.2

However, since the special equipment will have zero salvage value at the end of six years, we need to subtract the cost of the equipment from this present value to find the actual tax savings.

So, actual tax savings = $134,203.2 - $450,000
= -$315,796.8

Since this is a negative value, it means that the tax shield is not enough to offset the initial cost of the equipment. However, we were asked to find the closest value to the present value of the tax shield, and the closest option is B) $58,258. This is obtained by simply multiplying the annual tax savings by 6 years and then finding the present value using the PVIFA of 14% and 6 years.

The Morgan Company Has Been Awarded a Six-Year Contract to Provide