Question

Charlene is evaluating a capital budgeting project that should last for 4 years. The project requires $900,000 of equipment. She is unsure what depreciation method to use in her analysis, straight-line or the 3-year MACRS accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly over its 4-year life (ignore the half-year convention for the straight-line method). The applicable MACRS depreciation rates are 33%, 45%, 15%, and 7%. The company's WACC is 11%, and its tax rate is 40%. a. What would the depreciation expense be each year under each method? Round your answers to the nearest cent. Year Scenario 1 (Straight-Line) Scenario 2 (MACRS) b. Which depreciation method would produce the higher NPV? How much higher would the NPV be under the preferred method? Round your answer to two decimal places. Do not round your intermediate calculations.

Answer 1

a Depreciation Expenses in Each year Year Straight Line method Notel 225000 225000 225000 225000 Note 1 Depreciation Per under Straight Line= Cost of Asset-Salvage Value Number of years 900000-0 225000 a Depreciation Expenses in Each year Accelerated Method Year Cost of asset % Depreciation rate 900000 900000 900000 900000 Depreciation 33 297000 45405000 15 135000 63000

b Computation of Net Present value Particulars Initial Outflow cost of equipment) Less:Present Value of Tax saving on Depreciation(Note 2/ Note 3) Net Present value Straight Line Accelerated Method 900000 900000 | 279220 294594 620780 605406 Conclusion Straight line method produces higher Net present value Higher amount of Depreciation compare to accelerated method(620780-605406) 15374

Note 2 Present value Tax saving on Depreciation on Straight Line Year Depreciation Tax Savings@40% Annuity Factor@11% Present Value 225000 90000 0.901 81081 2 225000 90000 0.812 7 3046 225000 90000 0.731 65807 225000 90000 0.659 59286 Total 279220 22500 Note 3 Present value Tax saving on Depreciation on Accelerated method Year Depreciation Tax Savings @40% Annuity Factor@11% Present Value 1 297000 118800 0.901 107027 21 405000 162000 0.812) 131483 31 135000 54000 0.731 39484 63000 25200 0.659 16600 Total 294594