Problem $9-27$

Markov Manufacturing recently spent $$15$ million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is $35\%.$ The company plans to use straight$-$line depreciation.

a$.$ What is the annual depreciation expense associated with this equipment?

b$.$ What is the annual depreciation tax shield?

c$.$ Rather than straight$-$line depreciation, suppose Markov will use the MACRS depreciation method for five$-$year property. Calculate the depreciation tax shield each year for this equipment under this accelerated depreciation schedule.

d$.$ If Markov has a choice between straight$-$line and MACRS depreciation schedules, and its marginal corporate tax rate is expected to remain constant, which should it choose? Why?

e$.$ How might your answer to part $($d$)$ change if Markov anticipates that its marginal corporate tax rate will increase substantially over the next five years?

Equipment cost $$15,000\mathrm{.}00($thousand$)$

a$.$ Annual depreciation expense: $$3,000\mathrm{.}00$

b$.$ Annual depreciation tax shield: $$1,050\mathrm{.}00$

c$.$ Year $0$ Year $1$ Year $2$ Year $3$ Year $4$ Year $5$ Year $6$

MACRS Schedule: $20\mathrm{.}00\%32\mathrm{.}00\%19\mathrm{.}20\%11\mathrm{.}52\%11\mathrm{.}52\%5\mathrm{.}76\%$

Depreciation Expense: $$0$ $$3,000$ $$4,800$ $$2,880$ $$1,728$ $$1,728$ $$864$

Depreciation Tax Shield:

d$.$ In both cases, its total depreciation tax shield is the same. But with MACRS, it receives the depreciation tax shields sooner$$thus$,$ MACRS depreciation leads to a higher NPV of Markov$$s FCF$.$

e$.$ If the tax rate will increase substantially, than Markov may be better off claiming higher depreciation expenses in later years, since the tax benefit at that time will be greater.