Question

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 $700,000 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 project cost of capital is 8%, and its tax rate is 30%.
How much higher would it be? Round your answer to the nearest dollar?

Answer 1

Solution:

Step 1: Find depreciation for each method - Depreciation is an expense and we are getting tax shield on it so effective expense = Depreciation * (1 - Tax)

Step 2: Find the present value of expense using the cost of capital

Step 3: Compare the expense for these two methods for each year and in total

The difference is given in excel sheet under column difference

Calculations are given in the excel sheet