Depreciation methods Kristin is evaluating a capital budgeting project that shou
ID: 2719517 • Letter: D
Question
Depreciation methods
Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $900,000 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 14%, and its tax rate is 40%.
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
1
Calculation of depreciation expense be each year under each method:
Scenario 1
(Straight-Line):
Year 1
Year 2
Year 3
Year 4
Depreciation
=(Cost - Salvage value )/ life = (900000-0)/4
$ 225,000
$ 225,000
$ 225,000
$ 225,000
Scenario 2
(MACRS):
Year 1
Year 2
Year 3
Year 4
Depreciation %
33%
45%
15%
7%
Depreciation = Cost * Dep %
$ 297,000
$ 405,000
$ 135,000
$ 63,000
(900000*33%)
(900000*45%)
(900000*15%)
(900000*7%)
2
Calculation of NPV:
Scenario 1
(Straight-Line):
Year 0
Year 1
Year 2
Year 3
Year 4
Cost of Equipment
$ (900,000)
Tax Saving on Depreciation
$ 90,000
$ 90,000
$ 90,000
$ 90,000
(225000*40%)
(225000*40%)
(225000*40%)
(225000*40%)
Net Cash Flows (CF)
$ (900,000)
$ 90,000
$ 90,000
$ 90,000
$ 90,000
PVF (14%)
1.00000
0.87719
0.76947
0.67497
0.59208
PV= CF *PVF
$ (900,000.00)
$ 78,947.37
$ 69,252.08
$ 60,747.44
$ 53,287.22
NPV = Sum of PVs
$ (637,765.89)
Scenario 2
(MACRS):
Year 0
Year 1
Year 2
Year 3
Year 4
Cost of Equipment
$ (900,000)
Tax Saving on Depreciation
$ 118,800
$ 162,000
$ 54,000
$ 25,200
(297000*40%)
(405000*40%)
(135000*40%)
(63000*40%)
Net Cash Flows (CF)
$ (900,000)
$ 118,800
$ 162,000
$ 54,000
$ 25,200
PVF (14%)
1.00000
0.87719
0.76947
0.67497
0.59208
PV= CF *PVF
$ (900,000.00)
$ 104,210.53
$ 124,653.74
$ 36,448.46
$ 14,920.42
NPV = Sum of PVs
$ (619,766.85)
Hence, MACRS method shall provide higher NPV.
3
MACRS Method shall provide (619766.85) - (637765.89) =
$ 17,999.04
Higer NPV
1
Calculation of depreciation expense be each year under each method:
Scenario 1
(Straight-Line):
Year 1
Year 2
Year 3
Year 4
Depreciation
=(Cost - Salvage value )/ life = (900000-0)/4
$ 225,000
$ 225,000
$ 225,000
$ 225,000
Scenario 2
(MACRS):
Year 1
Year 2
Year 3
Year 4
Depreciation %
33%
45%
15%
7%
Depreciation = Cost * Dep %
$ 297,000
$ 405,000
$ 135,000
$ 63,000
(900000*33%)
(900000*45%)
(900000*15%)
(900000*7%)
2
Calculation of NPV:
Scenario 1
(Straight-Line):
Year 0
Year 1
Year 2
Year 3
Year 4
Cost of Equipment
$ (900,000)
Tax Saving on Depreciation
$ 90,000
$ 90,000
$ 90,000
$ 90,000
(225000*40%)
(225000*40%)
(225000*40%)
(225000*40%)
Net Cash Flows (CF)
$ (900,000)
$ 90,000
$ 90,000
$ 90,000
$ 90,000
PVF (14%)
1.00000
0.87719
0.76947
0.67497
0.59208
PV= CF *PVF
$ (900,000.00)
$ 78,947.37
$ 69,252.08
$ 60,747.44
$ 53,287.22
NPV = Sum of PVs
$ (637,765.89)
Scenario 2
(MACRS):
Year 0
Year 1
Year 2
Year 3
Year 4
Cost of Equipment
$ (900,000)
Tax Saving on Depreciation
$ 118,800
$ 162,000
$ 54,000
$ 25,200
(297000*40%)
(405000*40%)
(135000*40%)
(63000*40%)
Net Cash Flows (CF)
$ (900,000)
$ 118,800
$ 162,000
$ 54,000
$ 25,200
PVF (14%)
1.00000
0.87719
0.76947
0.67497
0.59208
PV= CF *PVF
$ (900,000.00)
$ 104,210.53
$ 124,653.74
$ 36,448.46
$ 14,920.42
NPV = Sum of PVs
$ (619,766.85)
Hence, MACRS method shall provide higher NPV.
3
MACRS Method shall provide (619766.85) - (637765.89) =
$ 17,999.04
Higer NPV
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