Question

1. Your firm, Agrico Products, is considering a tractor that would have a cost of $36,000, 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 $7,200 per year beginning the first year. (thus, annual cash flows would be $12,000 before taxes plus the savings that result from $7,200 depreciation.) The manager disagrees about weather the tractor would 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 do give 5 years of service. The service manager then states that some last for as long as 8 years.

2. Assume that if the tractor only lasts 4 years, then the firm would receive a tax credit in Year 4 because the tractor’s salvage value at the time is less than its book value. Under this scenario, the firm would not take depreciation expense in Year 5.

   Given this discussion, the CEO asks you to prepare a scenario analysis to determine the importance of the tractor’s life on the NPV. Use a 40% marginal federal-plus-state tax rate, a zero-salvage value, and a 10% WACC. Assuming each if the indicated lives have the same probability of occurring (probability 1/3), what is the tractor’s expected NPV?

Answer 1