Your firm, Agrico Products, is considering a tractor that would have a cost of $
ID: 2691899 • Letter: Y
Question
Your firm, Agrico Products, is considering a tractor that would have a cost of $36,000, would increase pretax operating cash flows before taking account of depreciation by $13,000 per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of $7,200 per year, beginning the first year. (Thus, annual cash flows would be $13,000 before taxes plus the tax savings that result from $7,200 of depreciation.) The managers are having a heated debate about whether the tractor would actually last 5 years. The controller insists that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors actually do give 5 years of service. The service manager then states that some last for as long as 8 years.
Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractor's life on the NPV. Use a 40% marginal federal-plus-state tax rate, a zero salvage value, and a 10% WACC. Assuming each of the indicated lives has the same probability of occurring (probability = 1/3), what is the tractor's expected NPV? (Hint: Use the 5-year straight-line depreciation for all analyses and ignore the MACRS half-year convention for this problem.)
Round your answers to two decimal places. Do not round intermediate calculations.
Explanation / Answer
If life = 5 years, depreciation = $7200 after tax cash flow = ($13000 - $7200)*(1-40%) + $7200 = $10680 life = 5 years Year Cash Flow, 5years Year 0 -36000 Year 1 10680 Year 2 10680 Year 3 10680 Year 4 10680 Year 5 10680 NPV = 4485.60 If life = 4 years, depreciation = $9000 after tax cash flow = ($13000 - $9000)*(1-40%) + $9000 = $11400 N = 4 years NPV = 136.47 If life = 8 years, depreciation = $4500 after tax cash flow = ($13000 - $4500)*(1-40%) + $4500 = $9600 N = 8 years NPV = 15215.29 Expected NPV = (15215.29 + 136.47 + 4485.60 )/3 =$6612.45
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