Question

DEPRECIATION METHODS

Charlene is evaluating a capital budgeting project that should last for 4 years. The project requires $625,000 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 35%.

1. 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)
   1	$	$
   2
   3
   4

2. Which depreciation method would produce the higher NPV?
   -Straight Line/MARCS
   
   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

625000 years 120000 Given Equipment cost Life Old machine depriciation Depriciation Rates 33% 45% 15.00% 7.00% Marginal Tax Rate WACC 35% 11% Solution a) Depriciation expense under different method Year Senario 1 Senario 2 (Straight Line) (MACRS) 156250 206250 156250 281250 156250 93750 156250 43750 625000 625000 where, Depreciation (Straight Line) = Equipment cost / Life of equipment Depreciation (MACRS) = Equipment cost X MACRS b) Which depreciation produce higher NPV We know that depreciation is used for tax saving purpose in evaluation of capital budgeting technique Year PVE C Depreciation |Depreciation Tax Saving Tax Saving PV Tax Saving PV Tax Saving (Straight Line) (MACRS) (Straight Line) (MACRS) (Straight Line) (MACRS) 156250 206250 54687.51 72187.5 0.901 49268.02 65033.78 156250 281250 54687.5 98437.5 0.812 44385.60 79894.08 156250 93750 54687.5 | 32812.5 0.731 39987.03 23992.22 4 156250 43750 54687.5 15312.5 0.659 36024.35 10086.82 PV TOTAL 169665.00 179006.90 where, Tax saving (Straight Line) Depreciation (Strainght Line) X Tax Rate Tax saving (MACRS) Depreciation (MACRS) X Tax Rate PVF (Present Value Factor) (1/(1+r)^n where r is discount rate, n is year PV (Present Value) CFC X PVF Hence, MACRS depreciation method shall be used Hence, MACRS Higher NPV of 179006.90 - 169665.00 = 9341.90