Question

Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $750,000 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 10%, and its tax rate is 30%.

1. 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	$	$

2. Which depreciation method would produce the higher NPV?

How much higher would the NPV be under the preferred method? Round your answer to the nearest cent.
$  

Answer 1

NPV Calculation using straight line Depreciation:

Year (t)	Intial outlay	Depreciation (straight line) (%) : 100%/4	Depreciation (Intial outlay *%depr.)	Before taxes cash flow (BTCF)	Taxable Income (BTCF - depreciation)	Income taxes (Taxable Income *30%)	After Tax Net Income (taxable income - taxes)	Net Cash Flow = ( Net Income + depreciation)	PV of Net cash flow @10%= NCF/ (1+10%)^t
0	-$750,000							-$750,000	-$750,000
1		25%	$187,500	$0	($187,500)	($56,250)	($131,250)	$56,250	$51,136
2		25%	$187,500	$0	($187,500)	($56,250)	($131,250)	$56,250	$46,488
3		25%	$187,500	$0	($187,500)	($56,250)	($131,250)	$56,250	$42,261
4		25%	$187,500	$0	($187,500)	($56,250)	($131,250)	$56,250	$38,420
NPV (sum of PVs)									-$571,695.07

Note: Assuming Before tax cash flow (BTCF) = 0 as no value is given

NPV Calculation using MACRS Depreciation:

Year (t)	Intial outlay	3-Year MACRS depreciation percentage	Depreciation (Intial outlay *% depr)	Before tax cash flow (BTCF)	Taxable Income (BTCF - depreciation)	Income taxes (Taxable Income *30%)	After Tax Net Income (taxable income - taxes)	Net Cash Flow = ( Net Income + depreciation)	PV of Net cash flow @10%= NCF/ (1+10%)^t
0	-$750,000							-$750,000	-$750,000
1		33%	$247,500	$0	($247,500)	($74,250)	($173,250)	$74,250	$67,500
2		45%	$337,500	$0	($337,500)	($101,250)	($236,250)	$101,250	$83,678
3		15%	$112,500	$0	($112,500)	($33,750)	($78,750)	$33,750	$25,357
4		7%	$52,500	$0	($52,500)	($15,750)	($36,750)	$15,750	$10,757
NPV (sum of PVs)									-$562,707.98

a.

Year	Scenario 1	Scenario 2
	(Straight-Line)	(MACRS)
1	$187,500	$247,500
2	$187,500	$337,500
3	$187,500	$112,500
4	$187,500	$52,500

b. MACRS depreciation method would produce the higher NPV

Higher would the NPV be under the preferred method = -$562,707.98 – (-$571,695.07) = $8,987.09