Question

Charlene is evaluating a capital budgeting project that should last for 4 years. The project requires $225,000 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.

Scenario 1 (Straight-Line)

Year 1

Year 2

Year 3

Year 4

Scenario 2 (MACRS)

Year 1

Year 2

Year 3

Year 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

1 straight line method

Time line			1	2	3	4
Depreciation	Cost of equipment/no. of years		-56250	-56250	-56250	-56250

MACR method

Time line		0	1	2	3	4
Cost of new machine		-225000
=Initial Investment outlay		-225000
3 years MACR rate			33.00%	45.00%	15.00%	7.00%
-Depreciation	=Cost of machine*MACR%		-74250	-101250	-33750	-15750

NPV straight line method

Time line		0	1	2	3	4
Cost of new machine		-225000
=Initial Investment outlay		-225000
Sales			0	0	0	0
Profits	Sales-variable cost		0	0	0	0
-Depreciation	Cost of equipment/no. of years		-56250	-56250	-56250	-56250
=Pretax cash flows			-56250	-56250	-56250	-56250
-taxes	=(Pretax cash flows)*(1-tax)		-36562.5	-36562.5	-36562.5	-36562.5
+Depreciation			56250	56250	56250	56250
=after tax operating cash flow			19687.5	19687.5	19687.5	19687.5
						0
						0
Total Cash flow for the period		-225000	19687.5	19687.5	19687.5	19687.5
Discount factor=	(1+discount rate)^corresponding period	1	1.11	1.2321	1.367631	1.51807041
Discounted CF=	Cashflow/discount factor	-225000	17736.48649	15978.8167	14395.3303	12968.7661
NPV=	Sum of discounted CF=	-163920.6005

NPV MACR method

Time line		0	1	2	3	4
Cost of new machine		-225000
=Initial Investment outlay		-225000
3 years MACR rate			33.00%	45.00%	15.00%	7.00%
Sales			0	0	0	0
Profits	Sales-variable cost		0	0	0	0
-Depreciation	=Cost of machine*MACR%		-74250	-101250	-33750	-15750
=Pretax cash flows			-74250	-101250	-33750	-15750
-taxes	=(Pretax cash flows)*(1-tax)		-48262.5	-65812.5	-21937.5	-10237.5
+Depreciation			74250	101250	33750	15750
=after tax operating cash flow			25987.5	35437.5	11812.5	5512.5
+Tax shield on salvage book value	=Salvage value * tax rate					0
=Terminal year after tax cash flows						0
Total Cash flow for the period		-225000	25987.5	35437.5	11812.5	5512.5
Discount factor=	(1+discount rate)^corresponding period	1	1.11	1.2321	1.367631	1.51807041
Discounted CF=	Cashflow/discount factor	-225000	23412.16216	28761.87	8637.19819	3631.25449
NPV=	Sum of discounted CF=	-160557.5152

NPV of MaCR method is higher by -160557.5152-(-163920.6005)=3363.09