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

Question

Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $400,000 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 13%, and its tax rate is 30%. 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 $ $

Explanation / Answer

Depreciation Methods Kristen is evaluating a capital budgeting project that should last 4 years.? The project requires $ 8000,000 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% as discussed in Appendix 12A. The company's WACC is 10% and is tax rate is 40% a. What would the depreciation expense be each year under each method? b. Which depreciation method would produce the higher NPV,and how much higher would it be? a. Depreciation under straight line is $ 2,000,000 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 =8000000 x .33= 2640000 Depreciation Year 2= 8000000 x .45= 3600000 Depreciation Year 3= 8000000 x .15= 1200000 Depreciation Year 4 = 8000000 x .07= 560000 b. MACRS depreciation will produce a higher NPV by $ 127816 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 = 2000000 x .40= 800000 x 0.909090909= 727273 Year 2 cash in due to tax shield = 2000000 x .40= 800000 x 0.826446281= 661157 Year 3 cash in due to tax shield = 2000000 x .40= 800000 x 0.751314801= 601052 Year 4 cash in due to tax shield = 2000000 x .40= 800000 x 0.683013455= 546411 Total Present value of tax shield under straight line depreciation= 2535892 Year 0 cash out - 8,000,000 x 1. ( present value of $1 at year 0) = -8000,000 Net Present Value (straight line depreciation) ............ -5464108 Present value of tax shield of depreciation under MACRS: Year 1 cash in due to tax shield = 2640000 x .40= 1056000 x 0.909090909= 960000 Year 2 cash in due to tax shield = 3600000 x .40= 1440000 x 0.826446281= 1190083 Year 3 cash in due to tax shield = 1200000 x .40= 480000 x 0.751314801= 360631 Year 4 cash in due to tax shield = 560000 x .40 = 224000 x 0.683013455= 152995 Total Present value of cash in due to tax shield under MACRS= 2663709 Year 0 cash out = -8000000 x 1.0 ( present value of 1 at year 0) = -8000000 NPV ( MACRS depreciation.) =-5336291 Difference in Net Present value between St line and MACRS depreciation is $ 127816 in favor of MACRS depreciation. -5464108 minus -5336291= -127816 Depreciation is a tax deductible expense. With depreciation, you save on paying income tax. So, the tax saving is a cash inflow. If Depreciation is not tax deductible, then you would have to pay higher income tax. Present value factor of $1 at 10% Year 0 =1 Year 1 = 1/1.1= 0.909090909 Year 2 = 0.909090909 divided by 1.10 =0.826446281

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