Question

Ms. T. Potts, the treasurer of Ideal China, has a problem. The company has just ordered a new kiln for $464,000. Of this sum, $58,000 is described by the supplier as an installation cost. Ms. Potts does not know whether the Internal Revenue Service (IRS) will permit the company to treat this cost as a tax-deductible current expense or as a capital investment. In the latter case, the company could depreciate the $58,000 straight-line over 5 years. The tax rate is 30% and the opportunity cost of capital is 5%.
a. What is the present value of the cost of the kiln if the installation cost is treated as a separate current expense?
b. What is the present value of the cost of the kiln if the installation cost is treated as a part of the capital investment?

Answer 1

Answer:

Ideal China

a) The present value of the cost of the kiln if the installation cost is treated as a separate current expense is:

= $318,304.

b) The present value of the cost of the kiln if the installation cost is treated as a part of the capital investment is:

= $363,776.

Explanation:

a) Data and Calculations:

Present value factor for 5 years at 5% = 0.784

Cost of new kiln = $464,000

Installation cost = $58,000

Present value of the cost of the kiln if the installation cost is treated as a separate current expense = $406,000 * 0.784 = $318,304

Present value of the cost of the kiln if the installation cost is treated as a part of the capital investment = $464,000 * 0.784 = $363,776