Question

Click here to read the eBook: Analysis of an Expansion Project DEPRECIATION METHODS Charlene is evaluating a capital budgeting project that should last for 4 years. The project requires $950,000 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 12%, 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? -Select- 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 under the straight line method = 950,000/4 = $237,500 per year

Depreciation under MACRS will be as per rates of 33%, 45%, 15% and 7% each year. These percentage will be as a % of $950,000 for each year.

	Scenario 1	Scenario 2
Year	(Straight line)	(MACRS)
1	237,500.00	313,500.00
2	237,500.00	427,500.00
3	237,500.00	142,500.00
4	237,500.00	66,500.00

(b): The answer is MACRS.

Explanation:  By comparing the two scenarios, the MACRs depreciation method in the early years has higher tax-deductible depreciation charges. This means the present value of the expected cash flows would be higher compared to those from the straight line depreciation method holding other factors constant and therefore the MACRS depreciation method is most likely to produce a higher project NPV.

(c): Here we will compute the difference in depreciation expense from the MACRS and the straight line depreciation method then estimate the tax implication on the incremental cash flow to estimate by how much the NPV would br higher under the MACRS method as compared to the straight line depreciation method.

Year	Depreciation expense difference	0.40*depreciation expense
1	76,000	30,400
2	190,000	76,000
3	-                 95,000	-                     38,000
4	-              171,000	-                     68,400

We then calculate the present value of these cash flows using the WACC = 12%. This will provide us with an estimate of NPV difference.

Year (n)	Cash flows	PVIF = 1/1.12^n	PV = cash flow*PVIF
1	30,400.00	0.89286	27,142.86
2	76,000.00	0.79719	60,586.73
3	-           38,000.00	0.71178	-     27,047.65
4	-           68,400.00	0.63552	-     43,469.44
		Total	17,212.51

Thus NPV will be higher by: $17,212.51