Depreciation Methods Wendy\'s boss wants to use straight-line depreciation for t

Question

Depreciation Methods

Wendy's boss wants to use straight-line depreciation for the new expansion project because he said it will give higher net income in earlier years and give him a larger bonus. The project will last 4 years and requires $600,000 of equipment. The company could use either 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 33.33%, 44.45%, 14.81%, and 7.41%. The company's WACC is 9%, and its tax rate is 35%.

What would the depreciation expense be each year under each method?

b. Which depreciation method would produce the higher NPV?

c. How much higher would it be? Round your answer to the nearest dollar.
$  

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

Explanation / Answer

The MACRS rates are 33.33%, 44.45%, 14.81%, and 7.41%. The first MACRS depreciation expense is 33.33%($6,00,000) = $199980. The others are calculated similarly. The applicable depreciation values are as follows for the two scenarios:

Scenario 1 Scenario 2

Year (Straight Line) (MACRS)

1 $150000 $199980

2 150000 266700

3 150000 88860

4 150000 44460

b. To find the difference in net present values under these two methods, we must determine the difference in incremental cash flows each method provides.The depreciation expenses cannot simply be subtracted from each other, as there are tax ramifications due to depreciation expense. The full depreciation expense is subtracted from Revenues to get operating income, and then taxes due are computed Then, depreciation is added to after-tax operating income to obtain the project’s operating cash flow. Therefore, if the tax rate is 35%,only 65% of the depreciation expense is actually subtracted out during the after-tax operating income calculation and the full depreciation expense is added back to calculate operating income. So, there is a tax benefit associated with the depreciation expense that amounts to 35% of the depreciation expense. Therefore, the differences between depreciation expenses under each scenario should be computed and multiplied by 0.35 to determine the benefit provided by the depreciation expense.

Depreciation Expense Depreciation Expense

Year Difference (2 – 1) Diff. × 0.35 (MACRS)

1 $49980 $17493

2 116700 40845

3 -61140 21399

4 -105540 36939

Now to find the difference in NPV to be generated under these scenarios, just enter the cash flows that represent the benefit from depreciation expense and solve for net present value based upon a WACC of 9%.

CF0 = 0; CF1 = 17493; CF2 = 40845; CF3 = -21399; CF4 = -36939; and I/YR =9 . Solve for NPV = $ 7759

So, all else equal the use of the accelerated depreciation method will result in a higher NPV (by $7759

]) than would the use of a straight-line depreciation method.

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