Your firm, Agrico Products, is considering a tractor that would have a cost of $

Question

Your firm, Agrico Products, is considering a tractor that would have a cost of $37,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of $7,400 per year, beginning the first year. (Thus, annual cash flows would be $12,000 before taxes plus the tax savings that result from $7,400 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 8% 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.)>>>>>> a.Tractor's NPV if actual life is 5 years. $ b.Tractor's NPV if actual life is 4 years. $ c.Tractor's NPV if actual life is 8 years. $ d.Tractor's expected NPV. $ Round your answers to two decimal places. Do not round intermediate calculations.

Explanation / Answer

There is one part missing in the question, which is the time for which this project is to be considered. I am assuming that the project is considered to be in-air till the time tractor is depreciated. So, if N = 5 years, tractor's depreciation = $37000/5 = $7400 After tax cash flows = (12000 - 7400) * (1-40%) + 7400 = 10160 NPV = -37000 + 10160 * ( 1 -1.08^-5)/0.08 = 3565.93 So, if N = 4 years, tractor's depreciation = $37000/4 = $9250 After tax cash flows = (12000 - 9250) * (1-40%) + 9250= 10900 NPV = -37000 + 10900 * ( 1 -1.08^-4)/0.08 = -897.82 So, if N = 8 years, tractor's depreciation = $37000/8 = $4625 After tax cash flows = (12000 - 4625) * (1-40%) + 4625= 9500 NPV = -37000 + 9500 * ( 1 -1.08^-8)/0.08 = 17593.07 Expected NPV = (17593.07 -897.02 + 3565.93)/3 = $6754

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