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Managers of the Jonathan Co

Accounting

Managers of the Jonathan Co. realize that the present value of the depreciation tax benefit is affected by the discount rate, the tax rate, and the depreciation rate. They have recently purchased a machine for $100,000 and they are trying to decide which depreciation method to use. There are only two alternatives available, and they must make an irrevocable selection of one method or the other right now. They have no uncertainty about the company's discount rate (it is 10 percent), but they are highly uncertain about the direction of future tax rates. The company's uncertainty stems from the fact that the existing tax rate is 30 percent, but congress is presently debating tax legislation that would dramatically increase the rate. If the legislation is passed it would go into affect in two years (after the Jonathan Co. has claimed two years of depreciation). How high would tax rates need to be in two years for the Jonathan Co. to be indifferent between depreciation Method 2 and depreciation Method 1 below?

 

 

Method 1

Method 2

Difference

Year 1

$30,000

$10,000

$(20,000)

Year 2

$40,000

$15,000

$(25,000)

Year 3

$10,000

$25,000

$ 15,000 

Year 4

$10,000

$25,000

$ 15,000 

Year 5

$10,000

$25,000

$ 15,000 

 

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