Depreciation methods Kristin is evaluating a capital budgeting project that shou

Question

Depreciation methods

Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $725,000 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 30%.

A) What would the depreciation expense be each year under each method? Round your answers to the nearest cent.

B) Which depreciation method would produce the higher NPV?


C) How much higher would the NPV be under the preferred method? Round your answer to two decimal places.
$  

Year Scenario 1
(Straight-Line) Scenario 2
(MACRS) 1 $   $   2 $   $   3 $   $   4 $   $  

Explanation / Answer

Ans b

Ans a Year SLM MACRS 1 Cost-Salvage Value/No of usefulLife 725000/4 1,81,250.00 Orginlal Cost * MACR Dep rate 725000*33%    2,39,250.00 2 Cost-Salvage Value/No of usefulLife 725000/4 1,81,250.00 Orginlal Cost * MACR Dep rate 725000*45%    3,26,250.00 3 Cost-Salvage Value/No of usefulLife 725000/4 1,81,250.00 Orginlal Cost * MACR Dep rate 725000*15%    1,08,750.00 4 Cost-Salvage Value/No of usefulLife 725000/4 1,81,250.00 Orginlal Cost * MACR Dep rate 725000*7%        50,750.00

Ans b

SLM MACRS Ans b Year Depreciation Tax Shield=Depreciation * Tax Rate DF @ 14% PV of Dep Tax Shield Depreciation Tax Shield=Depreciation * Tax Rate DF @ 14% PV of Dep Tax Shield 1 181250 54375            0.8772                           47,697.37 239250        71,775.00       0.8772                        62,960.53 2 181250 54375            0.7695                           41,839.80 326250        97,875.00       0.7695                        75,311.63 3 181250 54375            0.6750                           36,701.58 108750        32,625.00       0.6750                        22,020.95 4 181250 54375            0.5921                           32,194.37 50750        15,225.00       0.5921                           9,014.42                        1,58,433.11                     1,69,307.53 MACRS produces better NPV because present value of depreciation tax shield is greater. Ans c PV of Depreciation Tax shield under SLM                                 1,58,433.11 Pv of Depreciation Tax shield under MACRS                                 1,69,307.53 Incremental NPV in case of MACRS                                    10,874.42

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