Depreciation methods Kristin is evaluating a capital budgeting project that shou

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Depreciation methods

Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $950,000 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 11%, and its tax rate is 35%.

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

Scenario 1 (Straight-Line)

YR 1 $________

YR 2 $________

YR 3 $________

YR 4 $________

Scenario 2 (MACRS)

YR 1 $________

YR 2 $________

YR 3 $________

YR 4 $________

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

Explanation / Answer

Depreciation under straight line is: 950000/4 for each year

YR 1 $ 237,500

YR 2 $ 237,500

YR 3 $ 237,500

YR 4 $ 237,500

Depreciation based on MACRS accelerated method is:

Depreciation rate x cost of project = depreciation charge

Depreciation Year 1 : 950,000*0.33 = $ 313,500

Depreciation Year 2 : 950,000*0.45 = $ 427,500

Depreciation Year 3 : 950000*0.15 = $ 142,500

Depreciation Year 4 : 950000*0.07 = $ 66,500

b. Present value of tax shield under straight line depreciation is

Depreciation x .35 ( tax rate) = Tax Shield x Present Value Factor of 1 at year n = present value

Year 1 cash in due to tax shield = 237500 x .35= 83125*0.900901 = 74887.39
Year 2 cash in due to tax shield = 237500 x .35= 83125*0.811622 = 67466.11
Year 3 cash in due to tax shield = 237500 x .35= 83125*0.731191 = 60780.28
Year 4 cash in due to tax shield = 237500 x .35= 83125*0.658731 = 54757.01

Total Present value of tax shield under straight line depreciation = 257890.7979

Year 0 cash out = -950000*1. ( present value of $1 at year 0) = -950000

Net Present Value (straight line depreciation) = -950000 + 257890.7979 = -692109.20

Present value of tax shield of depreciation under MACRS:

Year 1 cash in due to tax shield = 313500*0.35 = 109725*0.900901 = 98851.35

Year 2 cash in due to tax shield = 427500*0.35 = 149625*0.811622 = 121439.01

Year 3 cash in due to tax shield = 142500*0.35 = 49875*0.731191 = 36468.17

Year 4 cash in due to tax shield = 66500*0.35 = 23275*0.658731 = 15331.96

Total Present value of cash in due to tax shield under MACRS= 272090.49

Year 0 cash out = -950000*1. ( present value of $1 at year 0) = -950000

NPV ( MACRS depreciation.) = -950000+272090.49 = -677909.51

Difference in Net Present value between St line and MACRS depreciation is $ 14199.69 in favour of MACRS Depreciation

-692109.20 - 677909.51 = -14199.69.

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