Corporate Finance Quiz: Depreciation Tax Shield
20 questions · exam conditions
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Depreciation Tax ShieldQuestion 1 of 20

A firm sells a piece of equipment for $20,000 at the end of a project. The equipment has a tax book value of $35,000 at the time of sale. The firm's marginal tax rate is 30%. What is the total after-tax cash flow generated by this sale?

$15,500
$20,000
$24,500
$14,000
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Corporate Finance Quiz

Corporate Finance Quiz: Depreciation Tax Shield

Practice Depreciation Tax Shield in Corporate Finance with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

What this quiz covers

This quiz focuses on Depreciation Tax Shield, giving you a quick way to practice the rules, question types, and explanations that matter most for Corporate Finance.

How to use this quiz

Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

All questions

Question 1

A firm sells a piece of equipment for $20,000 at the end of a project. The equipment has a tax book value of $35,000 at the time of sale. The firm's marginal tax rate is 30%. What is the total after-tax cash flow generated by this sale?

  1. $15,500
  2. $20,000
  3. $24,500 (correct answer)
  4. $14,000
Explanation: When an asset is sold for less than its book value, the resulting loss creates a tax saving (a tax shield on the loss).
  1. Sale Price (MV) = $20,000.
  2. Book Value (BV) = $35,000.
  3. Taxable Loss = MV - BV = \20,000 - $35,000 = -$15,000$.
  4. Tax Savings from Loss = Loss × Tax Rate = \15,000 \times 30% = $4,500$. This is a cash inflow (or reduction in taxes paid).
  5. Total After-Tax Cash Flow = Sale Price + Tax Savings = \20,000 + $4,500 = $24,500$.
    Distractor A incorrectly subtracts the tax saving. Distractor B ignores the tax effect of the loss. Distractor D incorrectly calculates tax on the sale price.

Question 2

A company is concluding a 4-year project. The equipment used cost $400,000 and was depreciated using straight-line depreciation over 4 years to a book value of zero. The company sells the equipment for $50,000. If the company's marginal tax rate is 25%, what is the after-tax cash flow from the sale of the equipment?

  1. $12,500
  2. $37,500 (correct answer)
  3. $50,000
  4. $62,500
Explanation: The after-tax cash flow from asset disposal is calculated as the sale price minus the taxes paid on any gain.
  1. Book Value (BV) at time of sale = $0.
  2. Sale Price (Market Value, MV) = $50,000.
  3. Taxable Gain = MV - BV = \50,000 - $0 = $50,000$.
  4. Taxes on Gain = Taxable Gain × Tax Rate = \50,000 \times 0.25 = $12,500$. This is a cash outflow.
  5. After-Tax Cash Flow = MV - Taxes on Gain = \50,000 - $12,500 = $37,500$.
    Distractor A is only the tax amount. Distractor C ignores the tax on the gain. Distractor D incorrectly adds the tax amount to the sale price.

Question 3

A company is evaluating a project with a large initial equipment purchase. The project's value is sensitive to its early-year cash flows. The company's WACC is 12%, and its tax rate is 25%. Which statement correctly describes the effect of choosing the MACRS depreciation method over the straight-line method for the equipment?

  1. MACRS will result in a lower total depreciation tax shield over the asset's life, reducing the project's overall NPV.
  2. The choice of depreciation method is an accounting decision that does not affect the project's actual cash flows or its NPV.
  3. MACRS will create higher depreciation tax shields in the early years of the project, increasing the present value of total tax shields and thus the project's NPV. (correct answer)
  4. Straight-line will provide a more predictable annual tax shield, which is always preferred for projects sensitive to early-year cash flows.
Explanation: MACRS is an accelerated depreciation method, meaning it allows for larger depreciation deductions in the early years of an asset's life compared to the straight-line method. While the total depreciation over the asset's life is the same under both methods, the timing differs. Due to the time value of money, receiving the tax savings (shields) earlier makes them more valuable. Therefore, MACRS increases the present value of the total tax shields, which in turn increases the project's Net Present Value (NPV).
Distractor A is incorrect because total depreciation is the same. Distractor B is incorrect because depreciation affects taxes paid, which is a cash flow. Distractor D is incorrect because while straight-line is predictable, higher early cash flow (from larger early tax shields under MACRS) is more valuable.

Question 4

A company plans to purchase an asset with a 5-year life. The current corporate tax rate is 25%. However, new legislation is expected to increase the rate to 30% starting in Year 3 of the asset's life. The company can choose between straight-line (SL) and an accelerated depreciation method. To maximize the project's NPV, which statement is most accurate?

  1. The company should prefer an accelerated method to maximize depreciation in early years when the time value of money impact is greatest.
  2. The company should prefer the straight-line method because it shifts more depreciation expense into the later years when the tax rate is higher. (correct answer)
  3. The choice of depreciation method is irrelevant because the total tax savings will be the same over the asset's life regardless of timing.
  4. The company should prefer an accelerated method because the higher tax rate in later years will magnify the tax shield on the remaining depreciation amounts.
Explanation: The value of a depreciation tax shield is the depreciation amount multiplied by the tax rate. To maximize the present value of tax shields, a firm should seek to take the largest depreciation deductions in years with the highest tax rates. An accelerated method front-loads depreciation into Years 1 and 2, when the tax rate is lower (25%). The straight-line method results in a more even distribution of depreciation, meaning a relatively larger portion of the total depreciation expense will be recognized in Years 3-5, when the tax rate is higher (30%). This maximizes the value of the tax shields and thus the project's NPV.
Distractor A ignores the critical information about the changing tax rate. Distractor C ignores both the time value of money and the changing tax rate. Distractor D contains flawed reasoning.

Question 5

A startup company invests in new equipment. For the first two years of operation, the company projects significant Net Operating Losses (NOLs) for tax purposes, even before accounting for depreciation on the new equipment. The company anticipates becoming profitable in Year 3. Assume tax laws allow for NOLs to be carried forward indefinitely. How should the firm view the depreciation tax shields from the new equipment in Years 1 and 2?

  1. The tax shields in Years 1 and 2 are valueless because the company is not paying taxes and the benefits expire.
  2. The tax shields provide an immediate cash refund from the government equivalent to the depreciation expense times the tax rate.
  3. The tax shields increase the company's NOL carryforward, creating a deferred tax asset whose value depends on future profitability. (correct answer)
  4. The tax shields are realized immediately because depreciation is always added back to determine operating cash flow.
Explanation: A depreciation tax shield has value because it reduces a firm's tax liability. If a firm has no tax liability due to a Net Operating Loss (NOL), the depreciation expense does not create an immediate tax saving. Instead, the depreciation expense increases the amount of the NOL. This larger NOL can be carried forward to offset taxable income in future profitable years. This creates a deferred tax asset. The value of the tax shield is not lost, but it is delayed, which reduces its present value.
Distractor A is incorrect because the benefits can be carried forward. Distractor B describes a tax refund system that is not standard practice. Distractor D confuses the accounting add-back for calculating OCF with the actual cash impact of the tax shield.

Question 6

Which statement best explains why the depreciation tax shield is a relevant incremental cash flow in capital budgeting analysis?

  1. It represents a direct subsidy payment received from the government for investing in capital assets.
  2. It reduces the amount of cash taxes a firm must pay relative to not having the depreciation expense. (correct answer)
  3. It adjusts the historical cost of an asset to its current market value on the firm's income statement.
  4. It is a non-cash expense that is added back to net income, and this accounting adjustment is the source of the cash flow.
Explanation: Depreciation is a tax-deductible expense. By reducing a firm's taxable income, it reduces the amount of taxes the firm actually pays in cash to the government. This reduction in cash outflow is an incremental cash flow attributable to the project. Therefore, the depreciation tax shield (Depreciation × Tax Rate) represents a real cash saving.
Distractor A is incorrect; it is a tax reduction, not a direct payment. Distractor C describes fair value accounting, which is unrelated. Distractor D describes the mechanical process of calculating OCF from net income but misidentifies the source of the cash flow; the add-back itself isn't a cash flow, it merely reverses a non-cash charge. The actual cash impact comes from lower tax payments.

Question 7

A company is considering two mutually exclusive projects, Project Alpha and Project Beta. Both projects require the same initial investment and have the same risk and operating cash flows before depreciation and taxes. Project Alpha uses an asset with a 3-year tax life, while Project Beta uses an asset with a 7-year tax life. Both assets will be depreciated using the straight-line method. Which of the following is most likely to be true?

  1. Project Beta will have a higher NPV because its tax shields provide more stable and predictable earnings.
  2. Both projects will add the same value because the total depreciation tax shield is identical for both.
  3. The choice of asset tax life does not impact NPV, as it is an accounting decision with no cash flow consequences.
  4. Project Alpha will have a higher NPV because the present value of its depreciation tax shields is greater. (correct answer)
Explanation: When evaluating projects with different depreciation schedules, you need to focus on the timing of tax benefits, not just their total amount. Depreciation creates tax shields by reducing taxable income, and like all cash flows, earlier tax savings are more valuable than later ones due to the time value of money. Project Alpha depreciates its asset over 3 years while Project Beta spreads the same total depreciation over 7 years. Since both projects have identical initial investments, the total depreciation amount is the same, but Alpha frontloads these deductions. This means Alpha generates larger annual tax shields in the early years (years 1-3) compared to Beta's smaller, spread-out deductions over 7 years. When you discount these tax benefits back to present value, Alpha's concentrated early tax shields are worth more than Beta's diluted later benefits. Option A incorrectly suggests that stability of earnings affects NPV calculation - NPV focuses on cash flows, not earnings smoothness. Option B makes the common mistake of ignoring timing; while total tax shields are equal in nominal terms, their present values differ significantly. Option C completely misses that depreciation method affects the timing of actual tax payments, which are real cash flow consequences, not mere accounting entries. Remember this principle: when comparing projects with identical total tax benefits, always favor the one that accelerates those benefits. The present value of money received sooner is always greater than money received later, making timing crucial in NPV analysis.

Question 8

A company is analyzing a 5-year project. The government has enacted a special tax holiday, setting the corporate tax rate to 0% for the next two years. The rate will revert to 25% for Year 3 and beyond. The project's asset will be depreciated using the straight-line method over 5 years. What is the value of the depreciation tax shield in Year 2?

  1. $0 (correct answer)
  2. A positive value, because the depreciation expense can be carried forward to years with a positive tax rate.
  3. A positive value, calculated using the 25% tax rate that applies in later years.
  4. A value equal to the full amount of the depreciation expense for Year 2.
Explanation: The depreciation tax shield is calculated as Depreciation Expense multiplied by the applicable tax rate for that year. In Year 2, the tax rate is 0%. Therefore, the depreciation tax shield for Year 2 is \text{Depreciation Expense} \times 0 = \0$. The depreciation in that year is used to offset operating income, but since the tax rate on that income is zero, no tax savings are generated in that specific year.
Distractor B incorrectly confuses this situation with a Net Operating Loss (NOL) carryforward. Distractor C uses the wrong year's tax rate. Distractor D confuses the tax shield with the depreciation expense itself.

Question 9

A company purchases an asset for $600,000 and depreciates it straight-line over 6 years to zero salvage value. At the beginning of Year 4, the company spends an additional $120,000 to overhaul the asset. This expenditure is capitalized and depreciated over the asset's remaining 3-year life. The company's tax rate is 20%. What is the total depreciation tax shield for Year 4?

  1. $20,000
  2. $24,000
  3. $28,000 (correct answer)
  4. $32,000
Explanation: The total depreciation in Year 4 comes from two sources: the original asset and the new capital expenditure.
  1. Depreciation from original asset: \frac{\600,000}{6 \text{ years}} = $100,000$ per year. This continues in Year 4.
  2. Depreciation from the overhaul: The $120,000 is capitalized and depreciated over the remaining 3 years (Years 4, 5, 6). The annual depreciation is \frac{\120,000}{3 \text{ years}} = $40,000$.
  3. Total Depreciation Expense in Year 4 = \100,000 + $40,000 = $140,000$.
  4. Total Depreciation Tax Shield in Year 4 = Total Depreciation × Tax Rate = \140,000 \times 0.20 = $28,000$.
    Distractor A represents the tax shield from only the original asset. Distractor B incorrectly depreciates the overhaul over the original 6-year life. Distractor D incorrectly expenses the entire overhaul in Year 4.

Question 10

A corporation invests in a new machine for $1,000,000. It is depreciated using the 5-year MACRS schedule (Y1=20%, Y2=32%). The firm's tax rate is 25%, and its cost of capital is 12%. An analyst correctly calculates the present value of the Year 1 tax shield as $44,643 and the present value of the Year 2 tax shield as $63,776. What is the primary reason the PV of the Year 2 tax shield is higher than the PV of the Year 1 tax shield?

  1. The corporate tax rate is expected to increase between Year 1 and Year 2.
  2. The time value of money has less impact in Year 2 than in Year 1.
  3. The half-year convention artificially deflates the Year 1 depreciation amount.
  4. The MACRS depreciation rate for Year 2 is significantly higher than for Year 1. (correct answer)
Explanation: When analyzing tax shields from depreciation, you need to understand that the tax shield value depends on both the depreciation amount and the present value calculation. The tax shield equals the depreciation expense multiplied by the tax rate, then discounted back to present value. Let's verify the logic with the given numbers. Year 1 depreciation is $1,000,000 × 20% = $200,000, creating a tax shield of $200,000 × 25% = $50,000. Year 2 depreciation is $1,000,000 × 32% = $320,000, creating a tax shield of $320,000 × 25% = $80,000. Even after discounting Year 2's larger tax shield by an additional year at 12%, it still exceeds Year 1's present value because the 60% increase in depreciation (from 20% to 32%) more than compensates for the extra discounting. The correct answer is D because the MACRS Year 2 rate of 32% is substantially higher than Year 1's 20% rate, creating a much larger tax shield that overwhelms the time value effect. Answer A is incorrect because nothing in the problem suggests changing tax rates—the 25% rate appears constant. Answer B misunderstands time value of money, which actually has more impact in Year 2 since cash flows are discounted for an additional year. Answer C mentions the half-year convention, but this doesn't explain why Year 2's present value exceeds Year 1's—both years follow the same MACRS schedule regardless of the convention. Remember: In tax shield problems, always compare the actual depreciation amounts first before considering discounting effects. The depreciation pattern often dominates the present value calculation.

Question 11

In its first year of operation, a project had an after-tax operating cash flow of $78,000. The project generated $150,000 in revenue and had $60,000 in cash operating expenses. The company's tax rate is 25%. What was the depreciation expense for the project in Year 1?

  1. $30,000
  2. $42,000 (correct answer)
  3. $72,000
  4. $10,500
Explanation: This problem requires working backwards using the operating cash flow (OCF) formula: OCF = (Sales - Cash Expenses)(1 - Tax Rate) + (Depreciation × Tax Rate).
  1. Plug in the known values: \78,000 = ($150,000 - $60,000)(1 - 0.25) + (\text{Depreciation} \times 0.25)$.
  2. Simplify the equation: \78,000 = ($90,000)(0.75) + 0.25 \times \text{Depreciation}$.
  3. Continue simplifying: \78,000 = $67,500 + 0.25 \times \text{Depreciation}$.
  4. Isolate the depreciation term: \78,000 - $67,500 = 0.25 \times \text{Depreciation}$.
  5. Solve for Depreciation: \10,500 = 0.25 \times \text{Depreciation} \implies \text{Depreciation} = \frac{$10,500}{0.25} = $42,000$.
    Distractor D is the result of a common conceptual error where the analyst assumes tax is paid on EBITDA and then depreciation is added back (i.e., OCF = After-tax EBITDA + Depreciation), which is incorrect.

Question 12

A firm purchases an asset for $500,000. It will be depreciated using the straight-line method over a 5-year life to a zero salvage value for tax purposes. The firm's marginal tax rate is 25% and its cost of capital is 10%. What is the present value of the depreciation tax shield specifically for Year 3 of the project?

  1. $18,783 (correct answer)
  2. $20,661
  3. $25,000
  4. $75,000
Explanation: The question requires a multi-step calculation: 1) find the annual depreciation, 2) calculate the annual tax shield, and 3) discount the Year 3 tax shield to its present value.
  1. Annual Depreciation = \frac{\500,000}{5 \text{ years}} = $100,000$ per year.
  2. Annual Depreciation Tax Shield (DTS) = \100,000 \times 0.25 = $25,000$.
  3. Present Value of Year 3 DTS = \frac{\25,000}{(1 + 0.10)^3} = \frac{$25,000}{1.331} = $18,782.87$, which rounds to $18,783.
    Distractor B incorrectly discounts for 2 years. Distractor C provides the undiscounted annual tax shield. Distractor D incorrectly sums the undiscounted tax shields for the first three years.

Question 13

An analyst is calculating the Year 2 after-tax operating cash flow for a project. The analyst's notes are shown below.

  • Sales: $500,000
  • Cash Operating Costs: $250,000
  • Depreciation: $100,000
  • Tax Rate: 20%
  • Analyst's Calculation: OCF = (Sales - Costs - Depreciation)(1 - Tax Rate) = ($500k - $250k - $100k)(0.80) = $120,000 Which error did the analyst make in the calculation?
  1. The analyst incorrectly subtracted depreciation before calculating taxes.
  2. The analyst used the wrong formula by failing to add back the non-cash depreciation expense. (correct answer)
  3. The analyst should have calculated the tax shield separately and added it to after-tax EBITDA.
  4. The analyst overstated the tax liability by including depreciation in the taxable income calculation.
Explanation: The analyst's calculation, (Sales - Costs - Depreciation)(1 - Tax Rate), correctly computes the project's Net Income. However, operating cash flow (OCF) must account for non-cash charges like depreciation. The standard formula for OCF starting from Net Income is OCF = Net Income + Depreciation. The analyst stopped at Net Income and failed to add back the $100,000 depreciation charge. The correct OCF is \120,000 + $100,000 = $220,000$.
Distractor A is incorrect because depreciation is correctly subtracted to find taxable income. Distractor C describes a valid alternative method, but the analyst's error was in the execution of their chosen method. Distractor D is incorrect because including depreciation reduces taxable income and thus the tax liability.

Question 14

A project is expected to generate annual revenues of $200,000 and incur cash operating expenses of $80,000. The project requires an asset that costs $300,000 and will be depreciated using the straight-line method over 5 years with no salvage value. The firm's tax rate is 30%. What is the project's annual after-tax operating cash flow?

  1. $42,000
  2. $84,000
  3. $102,000 (correct answer)
  4. $120,000
Explanation: The after-tax operating cash flow (OCF) can be calculated using the formula: OCF = (Sales - Cash Expenses)(1 - Tax Rate) + (Depreciation × Tax Rate).
  1. Annual Depreciation = \frac{\300,000}{5} = $60,000$.
  2. After-tax earnings from operations = (\200,000 - $80,000) \times (1 - 0.30) = $120,000 \times 0.70 = $84,000$.
  3. Depreciation Tax Shield = \60,000 \times 0.30 = $18,000$.
  4. OCF = \84,000 + $18,000 = $102,000.Alternatively,OCF=(EBIT)(1−T)+Depreciation.EBIT=. Alternatively, OCF = (EBIT)(1 - T) + Depreciation. EBIT = $200,000 - $80,000 - $60,000 = $60,000.OCF=. OCF = $60,000 \times (1 - 0.30) + $60,000 = $42,000 + $60,000 = $102,000$.
    Distractor A is Net Income. Distractor B is after-tax operating income but omits the depreciation tax shield. Distractor D is pre-tax operating income.

Question 15

A project's revenues and cash expenses are expected to grow with an anticipated inflation rate of 3% per year. The asset for the project will be depreciated based on its historical cost of $1,000,000. How does this anticipated inflation affect the real value of the depreciation tax shields over time?

  1. The real value of the tax shields will increase, as inflation effectively increases the real tax burden.
  2. The real value of the tax shields remains constant because depreciation is a fixed nominal expense.
  3. The effect cannot be determined without knowing the project's discount rate and the firm's tax rate.
  4. The real value of the tax shields will decrease because the tax savings are fixed in nominal terms. (correct answer)
Explanation: When analyzing depreciation tax shields in an inflationary environment, you need to understand how inflation affects the real purchasing power of fixed nominal cash flows over time. Depreciation tax shields represent the tax savings from deductible depreciation expenses. Since depreciation is calculated on historical cost ($1,000,000 in this case), the annual depreciation deductions are fixed in nominal dollar terms throughout the asset's life. The tax savings from these deductions are therefore also fixed in nominal terms. However, when inflation occurs at 3% annually, the purchasing power of each dollar decreases over time. A tax shield of, say, $50,000 in year five will buy fewer goods and services than the same $50,000 tax shield in year one. This means the real value (inflation-adjusted purchasing power) of the tax shields declines as inflation erodes their worth. Option A is incorrect because inflation doesn't increase the real tax burden on fixed nominal depreciation—it actually reduces the real value of the tax benefits. Option B misses the key point: while depreciation is indeed fixed in nominal terms, this fixity is precisely why inflation hurts its real value. Option C is wrong because you can determine the inflation effect on real value without knowing the discount rate or tax rate—inflation universally erodes the purchasing power of fixed nominal amounts. Key takeaway: Remember that inflation is the enemy of fixed nominal cash flows. Whenever you see depreciation based on historical cost in an inflationary scenario, the real value of those tax benefits will always decline over time.

Question 16

A company acquires an asset for $200,000 that qualifies for the 5-year MACRS recovery period. The company's tax rate is 21%. What is the depreciation tax shield for Year 1 of the asset's life? (Note: The 5-year MACRS rate for Year 1 is 20.00%)

  1. $4,200
  2. $8,400 (correct answer)
  3. $16,800
  4. $40,000
Explanation: The depreciation tax shield is the depreciation expense for the period multiplied by the marginal tax rate.
  1. Calculate Year 1 Depreciation using the given MACRS rate: \200,000 \times 20.00% = $40,000$.
  2. Calculate the Year 1 Depreciation Tax Shield (DTS): \40,000 \times 21% = $8,400.DistractorAresultsfromincorrectlyapplyingthehalf−yearconventiontoastraight−linecalculation:. Distractor A results from incorrectly applying the half-year convention to a straight-line calculation: ($200,000/5)/2 \times 21%.DistractorCresultsfromusingthedouble−decliningbalancemethodinsteadoftheMACRStablerate:. Distractor C results from using the double-declining balance method instead of the MACRS table rate: 2/5 \times $200,000 \times 21%$. Distractor D is the depreciation amount, not the tax shield.

Question 17

A firm is evaluating a project for the upcoming year. Projections are: Sales $1,000,000, Cash Costs $600,000, Depreciation $150,000, and Interest Expense $50,000. The corporate tax rate is 30%. What is the project's after-tax operating cash flow (OCF) for the year?

  1. $290,000
  2. $175,000
  3. $280,000
  4. $325,000 (correct answer)
Explanation: When calculating after-tax operating cash flow (OCF), you need to focus on the cash flows that result from the project's operations, excluding financing costs like interest expense. The most straightforward approach is to start with operating income and adjust for taxes. Here's the step-by-step calculation: Operating income (EBIT) equals Sales minus Cash Costs minus Depreciation: 1,000,000−600,000−150,000=250,0001,000,000 - 600,000 - 150,000 = 250,000. Next, calculate taxes on operating income: 250,000×0.30=75,000250,000 \times 0.30 = 75,000. The after-tax operating income is 250,000−75,000=175,000250,000 - 75,000 = 175,000. Finally, add back depreciation since it's a non-cash expense: 175,000+150,000=325,000175,000 + 150,000 = 325,000. This gives us answer D) $325,000. The wrong answers represent common mistakes: A) $290,000 incorrectly includes interest expense in the calculation, reducing the tax base to $200,000 and yielding $(200,000 - 60,000) + 150,000 = 290,000$. B) $175,000 represents after-tax operating income but forgets to add back the non-cash depreciation expense. C) $280,000 likely results from calculation errors or mixing up different cash flow formulas. Remember the key distinction: operating cash flow excludes financing costs like interest because you're measuring the project's operational performance independent of how it's financed. Always add back non-cash expenses like depreciation since they reduce taxable income but don't actually consume cash. The formula OCF = (EBIT - Taxes) + Depreciation is your reliable framework.

Question 18

A project utilizes an asset that was purchased 6 years ago for $250,000. The asset was fully depreciated over a 5-year MACRS recovery period. In Year 6, the project is still operating and generating revenue. The firm's tax rate is 22%. What is the depreciation tax shield related to this asset that should be included in the Year 6 cash flow analysis?

  1. $0 (correct answer)
  2. $11,000
  3. $5,500
  4. A negative value, as the asset is now creating a tax liability.
Explanation: The depreciation tax shield is calculated as Depreciation Expense × Tax Rate. Since the asset was fully depreciated over its 5-year recovery period, the depreciation expense in Year 6 is $0. Therefore, the depreciation tax shield for Year 6 is also $0 (\0 \times 22% = $0).Eventhoughtheassetisstillinuse,nofurtherdepreciationcanbeclaimedfortaxpurposes.DistractorBisbasedonanincorrectstraight−linedepreciationcalculation(). Even though the asset is still in use, no further depreciation can be claimed for tax purposes. Distractor B is based on an incorrect straight-line depreciation calculation ($250,000/5 \times 22%$). Distractor C incorrectly applies a half-year convention to this flawed calculation. Distractor D is conceptually incorrect.

Question 19

A firm with a 10% cost of capital and a 25% tax rate is comparing two depreciation plans for a $100,000 asset.

  • Plan X: Depreciate $50,000 in Year 1 and $50,000 in Year 2.
  • Plan Y: Depreciate $20,000 per year for 5 years.
    What is the present value of the incremental tax shield cash flow from choosing Plan X over Plan Y in Year 1?
  1. $7,500
  2. $6,818 (correct answer)
  3. $6,198
  4. $3,409
Explanation: The question asks for the present value of the incremental tax shield in Year 1 only.
  1. Year 1 Depreciation (Plan X) = $50,000.
  2. Year 1 Depreciation (Plan Y) = $20,000.
  3. Incremental Depreciation in Year 1 (X over Y) = \50,000 - $20,000 = $30,000$.
  4. Incremental Tax Shield in Year 1 = Incremental Depreciation × Tax Rate = \30,000 \times 0.25 = $7,500$.
  5. Present Value of Year 1 Incremental Tax Shield = \frac{\7,500}{(1 + 0.10)^1} = $6,818.18$, which rounds to $6,818.
    Distractor A is the undiscounted incremental tax shield. Distractor C is the present value of the Year 2 incremental tax shield, not Year 1. Distractor D reflects a multi-year calculation error.

Question 20

A company is installing a new manufacturing system. The invoice price from the vendor is $750,000. The company also pays $30,000 for shipping and $70,000 for site preparation and installation. Additionally, the company spends $50,000 to train employees on the new system. For tax purposes, what is the asset's depreciable basis?

  1. $750,000
  2. $820,000
  3. $850,000 (correct answer)
  4. $900,000
Explanation: An asset's depreciable basis includes its purchase price plus all costs required to get the asset in place and ready for its intended use. This includes shipping and installation costs. Employee training costs are typically expensed in the period they are incurred rather than being capitalized as part of the asset's cost.
Depreciable Basis = Invoice Price + Shipping + Installation = \750,000 + $30,000 + $70,000 = $850,000$.
Distractor A ignores shipping and installation. Distractor B includes one but not both of these costs. Distractor D incorrectly includes the employee training cost.