The Raincloud Inc. is in the paper products industry. Industry being very capital intensive has been using straight-line depreciation as the industry standard. The Raincloud Company is contemplating the purchase of a large milling machine that will cost $3 million. The machine will probably have a useful life of ten years, at which time the machine’s salvage value will be negligible. However, the machine is the most productive in its first five years. After that, increasing repairs and maintenance requirements will increase the machine’s downtime and decrease its efficiency. Prior experience indicates that repairs and maintenance expense will be $40,000 in the first year and will increase at a rate of 10% per year.

Required:

The CEO is contemplating the use of different depreciation methods and requests from you, his financial adviser, to provide a report answering the following questions in detail (in layman terms, at least paragraph long discussion)

1. I (CEO speaking) have read in a business magazine that for this type of asset an accelerated depreciation method such as double-declining balance is conceptually the most appropriate method. Why is it so? If you disagree, please let me know why?
2. 
   
3. Most firms in the industry use straight-line depreciation. Prepare (and earn that fat paycheck of yours) a comparative schedule for me showing the annual expense related to this machine if (1) straight-line or (2) double-declining balance depreciation is used. Include both depreciation and repairs and maintenance expense in your schedule (Round off to whole dollars where appropriate)
4. 
   
5. I am concerned that if I use double-declining balance depreciation, the earnings of the company, especially in the early years, will not look good in comparison with those firms using straight-line depreciation. Since the sale of the company in the near future is debated among the shareholders, how will a potential buyer view our earnings, in comparison with those of other companies in the industry?
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7. Our present machine is fully depreciated, and although not as productive as the new one would be, it is still working. I understand there would be some tax benefits to buying the new machine. Explain to me how depreciation is calculated for tax purposes and what the potential tax benefits are. (Assume that the equipment falls into five-year class, meaning it can be depreciated using a double-declining balance for tax purposes)

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The method of depreciation for a particular asset class is chosen based on the asset and how it gett... View the full answer