Depreciation methods Kristin is evaluating a capital budgeting project that shou
ID: 2649489 • Letter: D
Question
Depreciation methods
Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $875,000 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%.
What would the depreciation expense be each year under each method? Round your answers to the nearest cent.
Which depreciation method would produce the higher NPV?
-Select-Straight-LineMACRSItem 9
How much higher would the NPV be under the preferred method? Round your answer to two decimal places.
$
(Straight-Line) Scenario 2
(MACRS) 1 $ $ 2 $ $ 3 $ $ 4 $ $
Explanation / Answer
a. Depreciation under straight line is $ 218750 each year for 1st to 4th year.
Depreciation based on MACRS accelerated method is: Depreciation rate x cost of project = depreciation charge
Depreciation Year 1 =875000 x .33= 288750
Depreciation Year 2= 875000 x .45= 393750
Depreciation Year 3= 875000 x .15= 131250
Depreciation Year 4 = 875000 x .07= 61250
b. MACRS depreciation will produce a higher NPV by $ 13875
Present value of tax shield under straight line depreciation is
Depreciation x .4 ( tax rate) = Tax Shield x Present Value Factor of 1 at year n = present value
Year 1 cash in due to tax shield = 218750 x .35= 76562.5* 0.8929= 68363
Year 2 cash in due to tax shield = 218750 x .35= 76562.5*0.7972= 61036
Year 3 cash in due to tax shield = 218750 x .35= 76562.5*0.7118= 54497
Year 4 cash in due to tax shield = 218750 x .35= 76562.5*0.6355= 48655
Total Present value of tax shield under straight line depreciation= 232551
Year 0 cash out - 875000 x 1. ( present value of $1 at year 0) = -875000
Net Present Value (straight line depreciation) -642449
Present value of tax shield of depreciation under MACRS:
Year 1 cash in due to tax shield = 288750 x .35= 101063 x 0.8929= 90239
Year 2 cash in due to tax shield = 393750 x .35= 137813 x 0.7972= 109864
Year 3 cash in due to tax shield = 131250 x .35= 45938 x .7118= 32698
Year 4 cash in due to tax shield = 61250 x .35 = 21438 x 0.683013455= 13624
Total Present value of cash in due to tax shield under MACRS= 246425
Year 0 cash out = -875000 x 1.0 ( present value of 1 at year 0) = -875000
NPV ( MACRS depreciation.) =628575
Difference in Net Present value between St line and MACRS depreciation is $ 13875 in favor of MACRS depreciation.
-642449 minus -628575= -13875
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