Question

Markov Manufacturing recently spent $15 million to purchase some equipment used in the manufacture of disk drives. The firm expects that this equipment will have a useful life of five years, and its marginal corporate tax rate is 35%. Markov will sell the equipment for an anticipated $2 million at the end of 5 years. Markov’s cost of capital is 10%. a. Using straight line depreciation down to salvage value, calculate the NPV of the equipment purchase. b. Using MACRS with a five-year life, calculate the NPV of the equipment purchase. c. Which of the two depreciation methods would Markov prefer? d. Now assume that the company’s corporate tax rate increases to 50%, which of the two depreciation methods would Markov prefer?

Answer 1

		A	B	C	D	E	F
1	Year(Tax Rate =35%)	0	1	2	3	4	5
2	Initial Investment	15
3	Depreciation Straight line =15/5		3	3	3	3	3
4	Depreciation Tax Shield =35%* Depreciation		1.05	1.05	1.05	1.05	1.05
5	After Tax Salvage Value						1.3	(=0.65*2)
6	Free Cash Flow	-15	1.05	1.05	1.05	1.05	2.35
7	Discount Rate	10%
	NPV	-10.21	NPV(A7,B6:F6)+A6

a) NPV = -10.21

A B C D E F 1 Year(Tax Rate =35%) 0 1 2 3 4 5 2 Initial Investment 15 3 MACRS RATE 20% 32% 19% 11.52% 11.52% 4 Depreciation Tax Shield =35%* Initial Investment * MACRS Rate 1.05 1.68 1.008 0.6048 0.6048 5 After Tax Salvage Value 1.3 (=0.65*2) 6 Free Cash Flow -15 1.05 1.68 1.008 0.6048 1.9048 7 Discount Rate 10% NPV -10.30 NPV(A7,B6:F6)+A6
NPV = -10.30 Markov should prefer straight line method A B C D E F 1 Year(Tax Rate =50%) 0 1 2 3 4 5 2 Initial Investment 15 3 Depreciation Straight line =15/5 3 3 3 3 3 4 Depreciation Tax Shield =50%* Depreciation 1.5 1.5 1.5 1.5 1.5 5 After Tax Salvage Value 1 (=0.5*2) 6 Free Cash Flow -15 1.5 1.5 1.5 1.5 2.5 7 Discount Rate 10% NPV -8.69 NPV(A7,B6:F6)+A6 1 Year(Tax Rate =50%) 0 1 2 3 4 5 2 Initial Investment 15 3 MACRS RATE 20% 32% 19.2% 11.52% 11.52% 4 Depreciation Tax Shield =50%* Initial Investment * MACRS Rate 1.5 2.4 1.44 0.864 0.864 5 After Tax Salvage Value 1 (=0.5*2) 6 Free Cash Flow -15 1.5 2.4 1.44 0.864 1.864 7 Discount Rate 10% NPV -8.82 NPV(A7,B6:F6)+A6 d) at 50% rate Staright line method should be selected