Question

Charlene is evaluating a capital budgeting project that should last for 4 years. The project requires $700,000 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 Scenario 1 (Straight-Line) Scenario 2 (MACRS) 1 $ $ 2 3 4

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. Do not round your intermediate calculations.

Answer 1

Answer (a):

Straight line:

Annual depreciation = (Cost - Salvage value) /Useful life =(700000 - 0) / 4 = $175,000

Answer (b):

Working:

Let is first calculate PV of Depreciation tax shield under both scenarios:

As we observe, MACRS would produce higher NPV and hence MACRs would be preferred method.

NPV under MACRs method would be higher by = 200487.73 - 190024.80 = $10,462.93