Tax Depreciation Methods and the Time Value of Money
The following two depreciation methods are acceptable for tax purposes:
(a) Straight line with a half year convention. The half year convention is the assumption that all assets are acquired in the middle of the year. Therefore, a half year’s depreciation is allowed in the first year.
(b) 200% declining balance with a half year convention. There is a switch to straight line depreciation on the remaining cost when straight line yields a larger amount than does 200% declining balance. On January 1, 2008, Marci Company purchased a piece of equipment for $350,000. The equipment has an estimated useful life of five years and no estimated residual value.
Instructions:
1. For tax purposes, depreciation reduces taxes payable by reducing taxable income. If the tax rate is 40%, for example, a $100 depreciation deduction will reduce taxes by $40. Ignoring the time value of money, calculate the total reduction in taxes Marci will realize through the recovery of the asset cost over the life of the equipment. Assume that the tax rate is 40%. Is the answer the same for each of the two acceptable depreciation methods?
2. For each of the acceptable methods, compute the present value (as of January 1, 2008) of the depreciation tax savings. Assume that the appropriate interest rate is 10% and that the tax savings occur at the end of the year.
3. Should a company be required to use the same depreciation method in its financial statements as it uses for tax purposes?