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 $750,000 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. YEAR 1-4 Scenario 1 (straight-line) Scenario 2 (MACRS) Which depreciation method would produce the higher NPV? How much higher would the NPV be under the preferred method? Round your answer to two decimal places.

Explanation / Answer

Scenario -1 Straight-line Depreciation Year Annual Depreciation Tax shield due to depreciation Depn*35% PV F @ 11% WACC PV @ 11% 1 187500 65625 0.9009 59121.56 2 187500 65625 0.81162 53262.56 3 187500 65625 0.73119 47984.34 4 187500 65625 0.65873 43229.16 NPV of depn. Tax shield for 4 yrs.= 203597.63 Or,( PVoA F 3.10244,11%,4)*65625= 203597.63 Scenario -2 MACRS Depn. Year Annual Depreciation Tax shield due to depreciation Depn*35% PV F @ 11% WACC PV @ 11% 1 247500 86625 0.9009 78040.46 2 337500 118125 0.81162 95872.61 3 112500 39375 0.73119 28790.61 4 52500 18375 0.65873 12104.16 NPV of depn. Tax shield for 4 yrs.= 214807.85 NPV of depn. Tax shield Straight-line Depreciation 203597.63 MACRS Depn. 214807.85 Difference 11210.22 MACRS Depn. Method produces higher NPV by $11,210.22 Money received/saved in earlier years of the project has more value than that in later years. Under St.line method, only 50% value of the asset is depreciated in the first 2 Yrs. as against, 78% under MACRS.- Hence more savings due to reduced tax outflow ,in the first 2 years.

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