Question

Suppose that dividend yield is 6%, depreciation is 12%, and the corporate tax rate is 35%. What would be the marginal cost of each dollar of machinery investment under the following situations:

a. Firms are allowed to expense the machine.

b. There is an investment tax credit of 8%.

With all math shown

Answer 1

a) When the firm can expense the machine (take the full deduction immediately), the cost of the investment is reduced by 35¢ cents for each dollar spent (because the firm saves 35¢ per dollar in taxes). Therefore, the marginal cost of the investment is the calculation shown reduced by the tax benefit, or
(depreciation + dividend)(1 – .35) = (0.12 + 0.06)(0.65) = 0.117 per dollar.

b) An investment tax credit reduces the cost of the investment even further. If the investment tax credit were included in the tax system described in a, the net cost to the firm would be

(depreciation + dividend)x(1 – .35 – the ITC) = (0.12 + 0.06)(0.65 – .08) = (0.18)(0.57) = 0.1026 per dollar.