DEPRECIATION & TAX SOLUTION

1. The Big-Deal Company has purchased new furniture for their offices at a retail price of $125,000. An
additional $20,000 has been charged for insurance, shipping, and handling. The company expects to use the
furniture for 10 years (useful life = 10 years) and then sell it at a salvage (market) value of $15,000. Use the SL
method of depreciation to answer these questions. (7.6)
a. What is the depreciation during the second year?
b. What is the BV of the asset at the end of the first year?
c. What is the BV of the asset after 10 years?
SOLUTION:
Basis = $145,000 = 125,000 +20,000
(a) d2 = ($145,000 $15,000)/10 = $13,000
(b) BV1 = $145,000 $13,000 = $132,000
(c) BV10 = $145,000 $13,000(10) = $15,000
2. Cisco Systems is purchasing a new bar code scanning device for its service center in San Francisco. The
table that follows lists the relevant cost items for this purchase. The operating expenses for the new system are
$10,000 per year, and the useful life of the system is expected to be five years. The SV for depreciation purposes is
equal to 25% of the hardware cost. (7.7)
Cost Item Cost
Hardware $160,000
Training $15,000
Installation $15,000
a. What is the BV of the device at the end of year three if the SL depreciation method is used?
b. Suppose that after depreciating the device for two years with the SL method, the firm decides to switch to the
double declining balance depreciation method for the remainder of the devices life (the remaining three years).
What is the devices BV at the end of four years?
SOLUTION:
Basic cost = $160,000 + $15,000 + $15,000 = $190,000
SV = 25% * 160,000 = $40,000
(a) d = ($190,000 $40,000)/5 = $30,000
BV3 = $190,000 (3)($30,000) = $100,000
(b) BV2 = $190,000 (2)($30,000) = $130,000
R = 2/3 for the double declining balance method
BV4 = $130,000(1 2/3)2 = $14,444.44

3. An asset for drilling was purchased and placed in service by a petroleum production company. Its cost basis
is $60,000, and it has an estimated MV of $12,000 at the end of an estimated useful life of 14 years. Compute the
depreciation amount in the third year and the BV at the end of the fifth year of life by each of these methods: (7.8)
a. The SL method.
b. The 200% DB method with switchover to SL.
SOLUTION:

4. A construction company is considering depreciation to the SL method for a general purpose hauling truck.
The cost basis of the truck is $100,000, and the expected salvage value for depreciation purposes is $8,000. The
company will use the truck for eight years and will depreciate it over this period of time with the SL method.
What is the depreciation in the amount of depreciation that would be claimed in year five? (7.12)
SOLUTION:
Straight-line depreciation in year five would be ($100,000 $8,000)/8 = $11,500.

5. The La Salle Bus Company has decided to purchase a new bus for $85,000 with a trade-in of their old bus.
The old bus has a BV of $10,000 at the time of the trade-in. The new bus will be kept for 10 years before being
sold. Its estimated SV at that time is expected to be $5,000. However, buses have a nine-year class recovery period.
First, we must calculate the cost basis. The basis is the original purchase price of the bus plus the BV of the old bus
that was traded in. Thus, the basis is $85,000 + $10,000, or $95,000.
Construct the tabular for Depreciation & Book Value using:
Straight line method
DB method
DB with Switchover to SL Depreciation
SOLUTION:
Straight line method

DB method:
R = 2/9 = 0.2222; d1 = $95,000(0.2222) = $21,111;
DB with Switchover to SL Depreciation

6. A highly specialized piece of equipment has a first cost of $50,000. If this equipment is purchased, it will
be used to produce income (through rental) of $20,000 per year for only four years. At the end of year four, the
equipment will be sold for a negligible amount. Estimated annual expenses for upkeep are $3,000 during each of
the four years. The firms effective income tax rate is 40%.
If the after-tax MARR is 7% per year, should the equipment be purchased?
Note: Depreciation is given in this case as below:

SOLUTION:
7. The Ajax Semiconductor Company is attempting to evaluate the profitability of adding another integrated
circuit production line to its present operations. The company would need to purchase two or more acres of land for
$275,000 (total). The facility would cost $60,000,000 and have no net MV at the end of five years. The facility will
be depreciated using in five years. An increment of working capital would be required, and its estimated amount is
$10,000,000. Gross income is expected to increase by $30,000,000 per year for five years, and operating expenses
are estimated to be $8,000,000 per year for five years. The firms effective income tax rate is 40%.
(a) Set up a table and determine the ATCF for this project.
(b) Is the investment worthwhile when the after-tax MARR is 12% per year?

SOLUTION:

- Acquisitions of land, as well as additional working capital, are treated as nondepreciable capital investments
whose MVs at the end of year five are estimated to equal their first costs
- The depreciable property ($60,000,000) will be disposed of for $0 at the end of year five, and a loss on
disposal of $6,912,000 will be claimed at the end of year five. Because the selling price (MV) is zero, the loss on
disposal equals our BV of $6,912,000.
- A tax credit of 0.40($6,912,000) = $2,764,800 is created at the end of year five. The after-tax IRR is
obtained from entries in column E of Table 7-8 and is found to be 12.5%.
- The after-tax PW equals $936,715 at MARR = 12% per year. Based on economic considerations, this
integrated circuit production line should be recommended because it appears to be quite attractive.
 8. A firm must decide between two system designs, S1 and S2, whose estimated cash flows are shown in the
following table. The effective income tax rate is 40%. Both designs have a recovery period of five years. If the
after-tax desired return on investment is 10% per year, which design should be chosen?

DESIGN S1 DESIGN S2

SOLUTION:
 We cant directly compare the PW of the after-tax cash flows because of the difference in the lives of the
alternatives. We can, however, directly compare the AWs of the ATCFs by using the repeatability assumption from
Chapter 6. AWS1(10%) = PWS1(A/P, 10%, 7) = $1,411(0.2054) = $290
AWS2(10%) = PWS2(A/P, 10%, 6) = $16,681(0.2296) = $3,830 Based on an after-tax annual worth analysis,
Design S1 is preferred since it has the greater (less negative) AW. Neither design however makes money, so if a
system is not required, dont recommend either one.