Information about a project Darcy Company is considering is as follows:
Investment $1,000,000
Revenues $700,000
Variable costs $140,000
Fixed out-of-pocket costs $80,000
Cost of capital 12%
Tax rate 40%
The property is considered 5-year property for tax purposes. The company plans to use MACRS and dispose of the property at the end of the sixth year. No salvage value is expected. Assume all cash flows occur at the end of the year. Round amounts to dollars.
The tax savings from depreciation in Year 2 would be
To find the tax savings from depreciation in Year 2, we need to calculate the depreciation expense using the Modified Accelerated Cost Recovery System (MACRS) and then determine the tax savings based on the depreciation tax shield.
Step 1: Calculate the annual depreciation expense using MACRS:
Since the property is considered 5-year property for tax purposes, we will use the MACRS 5-year schedule to calculate the depreciation expense.
The MACRS 5-year schedule assigns the following percentages for each year:
Year 1: 20%
Year 2: 32%
Year 3: 19%
Year 4: 12%
Year 5: 12%
Year 6: 5%
Since we are looking for the tax savings from depreciation in Year 2, we will use the Year 2 percentage of 32%.
Depreciation expense in Year 2 = 32% * Investment = 0.32 * $1,000,000 = $320,000
Step 2: Calculate the tax savings from depreciation in Year 2:
To calculate the tax savings, we need to multiply the depreciation expense by the tax rate.
Tax savings from depreciation in Year 2 = Depreciation expense in Year 2 * Tax rate = $320,000 * 0.40 = $128,000
Therefore, the tax savings from depreciation in Year 2 would be $128,000.