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 $600,000 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 company's WACC is 9%, and its tax rate is 45%.

1. Which depreciation method would produce the higher NPV?
   
   How much higher would it be? Round your answer to the nearest dollar.

Answer 1

Alternative 1		Amount in dollar
Calculation of NPV
		Year 1	Year2	Year 3	Year 4
Investment	-600,000
Depreciation		150000	150000	150000	150000
Net inflow	-600,000	150,000	150,000	150,000	150,000
Tax- 45%		67,500	67,500	67,500	67,500
Inflow after tax		82,500	82,500	82,500	82,500
NPV	($332,723.11)
NPV = -600000 + 82500/(1.09)^1 + 82500/(1.09)^2 +82500/(1.09)^3 +82500/(1.09)^4 = -600000 + 82500/1.09 +82500/ 1.1881+ 82500/1.295 +82500/1.412 = -600000 + 75688 + 69439 + 63707 + 58428 = -600000 + 267262 = - 332738, it is near about.
Alternative 2		Amount in dollar
Calculation of NPV
		Year 1	Year2	Year 3	Year 4
Investment	-600,000
Depreciation		199980	266700	88860	44460
Net inflow	-600,000	199,980	266,700	88,860	44,460
Tax- 45%		89,991	120,015	39,987	20,007
Inflow after tax		109,989	146,685	48,873	24,453
NPV	($320,568.79)
NPV cal culation as per alternative 1.
So alternative 2 is more favourable as NPV is less negetive.