Question

1. Epiphany Industries is considering a new capital budgeting project that will last for three years. Epiphany plans on using a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental cash flow projections:
   

Year	0	1	2	3
Sales (Revenues)		100,000	100,000	100,000
- Cost of Goods Sold (50% of Sales)		50,000	50,000	50,000
- Depreciation		30,000	30,000	30,000
= EBIT		20,000	20,000	20,000
- Taxes (35%)		7000	7000	7000
= unlevered net income		13,000	13,000	13,000
+ Depreciation		30,000	30,000	30,000
+ changes to working capital		-5000	-5000	10,000
- capital expenditures	-90,000

1. Q1 : Are they using MACRS? Explain.
2. Q2 : What’s EBITDA here?

Answer 1

Answer 1

MACRS is used for the computation of deduction of tax in respect of depreciation for those assets on which depreciation is charged. In terms of degree of deduction it is found that greater deduction is done in the earlier years while smaller in the latter period.

MACRS = Cost ˣ 1Useful life ˣ A ˣ Depreciation convention

In the 2^nd year the formula is

MACRS = (Cost – previous year depreciation) ˣ 1Useful life ˣ A

Where A = 100% or 150% or 200%

There are three conventions of depreciations. These are mid-month, mid-quarter, half-year conventions.

Depreciation to be charged either adopting 150% declining balance or 200% declining balance or straight method.

In the given problem life time of the asset is 3 years. It is assumed that half year convention to be applied and the two other conventions are not relevant as it is further assumed that the firm has started its operation mid of the year.

Depreciation at the end of the first year is

$90000 ˣ1/3 ˣ200% declining balance ˣ ½ half year convention

= $90000 ˣ33.33% ( Using the three year convention table relating to 200% declining

                                 balance)

= $30000

Next year depreciation amount

(Cost – previous year depreciation) ˣ ˣ A

=($90000 - $30000)ˣ1/3 ˣ A     [A = 200% declining method]

= $60000ˣ44.45%

= $26670

3^rd year in the same manner the amount of depreciation is

($90000 - $30000 - $26670) ˣ14.81%

= $4936

While in case of the firm the rule of either 200% DB method or 150% DB method are used that says greater deduction in the earlier period and smaller latter period.

Here every year depreciation is taken $30000

It means here GDS using straight line method is used where equal yearly deduction is made.

Answer 2

EBITDA stands for earnings before interest tax depreciation and amortisation

Here in this problem

EBITDA = Net income +tax+ depreciation ( No interest data and amortisation found)

1^st year EBITDA = $13000 + $7000 + $30000 = $50000

There is no change in the 2^nd year and 3^rd year data so

2nd year EBITDA = $13000 + $7000 + $30000 = $50000

3rd year EBITDA = $13000 + $7000 + $30000 = $50000