Your firm, Agrico Products, is considering a tractor that would have a cost of $

Question

Your firm, Agrico Products, is considering a tractor that would have a cost of $35,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of $7,000 per year, beginning the first year. (Thus, annual cash flows would be $12,000 before taxes plus the tax savings that result from $7,000 of depreciation.) The managers are having a heated debate about whether the tractor would actually last 5 years. The controller insists that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors actually do give 5 years of service. The service manager then states that some last for as long as 8 years. Given this discussion, the CFO asks you o prepare a scenario analysis o determine the importance o the tractor's eo the NPV se a 40% margra federal plus statetacrate a ze sa va evalue and a L% WACC. Assuming each of the indicated lives has the same probability of occurring (probability-1/3), what is the tractor's expected NPV? (Hint: Use the 5-year straight-line depreciation for all analyses and ignore the MACRS half-year convention for this problem.) Round your answers to two decimal places. a. Tractor's NPV if actual life is 5 years. b. Tractor's NPV if actual life is 4 years. c. Tractor's NPV if actual life is 8 years. d. Tractor's expected NPV

Explanation / Answer

Increase in post tax operating cash flows = 12000*(1-0.40)= $          7,200 Tax shield on depreciation = 7000*0.40 = $          2,800 After tax incremental annual cash inflows $        10,000 a) NPV if life is 5 years = 10000*(1.11^5-1)/(0.11*1.11^5)-35000 = $    1,958.97 b) NPV if life is 4 years = 10000*(1.11^4-1)/(0.11*1.11^4)-35000 = $ (3,975.54) c) NPV if life is 8 years = 10000*(1.11^8-1)/(0.11*1.11^8)-35000 = $ 16,461.23 d) Expected NPV = 1958.97*1/3+(-3975.54/3)+16461.23/3 = $    4,814.88

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