Wendy\'s boss wants to use straight-line depreciation for the new expansion proj

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%.

Explanation / Answer

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.

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