Question

At the start of a project, a firm assumed that a machine would be sold at the end of the project at 20 million. The firm used straight-line depreciation method based on the book value of 20 million at the end of the project for the machine. However, at the end of the project the machine is sold for 11 million instead. If marginal tax rate is 40%, then the firm will

A.) Recieve 4.40 million from the IRS, since the taxes were overpaid

B.) Pay additional taxes of 8 million, since the taxes were underpaid

C.) Pay additional taxes of 4.4 million, since the taxes were underpaid

D.) Have 14.60 million in after-tax proceeds from the sale of the machine

E.) Have 9 million in after-tax proceeds from the sale of the machine?

Answer 1

Answer: Option C - Pay additional taxes of 4.4 million, since the taxes were underpaid

Explanation: Assuming the economic life of 1 year, as it is not mentioned in the question. Since the machinery is of worth $20 million and the entire $20 million is charged as depreciation, the company initially pays no tax liability.

However, in the real scenario, the depreciation is reduced to 9 million i.e. (20-11=9 million). This means 11 million being the taxable income at the rate of 40%. This implies 11 million x 40%= 4.4 million tax liability.

The formula for depreciation being {(book value-scrap value)/economic life}