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Kristin is evaluating a capital budgeting project that should last for 4 years.

ID: 2634507 • Letter: K

Question

Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $375,000 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 35%.

Year Scenario 1
(Straight-Line) Scenario 2
(MACRS) 1 $93,750 $123,750 2 $93,750 $168,750 3 $93,750 $56,250 4 $93,750 $26,250

Explanation / Answer

Scenario 1(Straight line depreciation)

Tax

35%

year

1

2

3

4

Depreciation

93750

93750

93750

93750

Tax shield(Dep*Tax)

32812.5

32812.5

32812.5

32812.5

P.V@12%

29296.88

26157.92

23355.29

20852.94

NPV of tax shield

99663.03

Scenario 2(MACRS)

Tax

35%

year

1

2

3

4

Depreciation

123750

168750

56250

26250

Tax shield(Dep*Tax)

43312.5

59062.5

19687.5

9187.5

P.V@12%

38671.88

47084.26

14013.17

5838.822

NPV of tax shield

105608.1

Scenario 2(MACRS) have higher NPV due to tax shield.

The NPV under MACRS would be higher by (105608.1-99663.03) = 5945.07

Scenario 1(Straight line depreciation)

Tax

35%

year

1

2

3

4

Depreciation

93750

93750

93750

93750

Tax shield(Dep*Tax)

32812.5

32812.5

32812.5

32812.5

P.V@12%

29296.88

26157.92

23355.29

20852.94

NPV of tax shield

99663.03