Kristin is evaluating a capital budgeting project that should last for 4 years.
ID: 2634507 • Letter: K
Question
Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $375,000 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 12%, and its tax rate is 35%.
Year Scenario 1(Straight-Line) Scenario 2
(MACRS) 1 $93,750 $123,750 2 $93,750 $168,750 3 $93,750 $56,250 4 $93,750 $26,250
Explanation / Answer
Scenario 1(Straight line depreciation)
Tax
35%
year
1
2
3
4
Depreciation
93750
93750
93750
93750
Tax shield(Dep*Tax)
32812.5
32812.5
32812.5
32812.5
P.V@12%
29296.88
26157.92
23355.29
20852.94
NPV of tax shield
99663.03
Scenario 2(MACRS)
Tax
35%
year
1
2
3
4
Depreciation
123750
168750
56250
26250
Tax shield(Dep*Tax)
43312.5
59062.5
19687.5
9187.5
P.V@12%
38671.88
47084.26
14013.17
5838.822
NPV of tax shield
105608.1
Scenario 2(MACRS) have higher NPV due to tax shield.
The NPV under MACRS would be higher by (105608.1-99663.03) = 5945.07
Scenario 1(Straight line depreciation)
Tax
35%
year
1
2
3
4
Depreciation
93750
93750
93750
93750
Tax shield(Dep*Tax)
32812.5
32812.5
32812.5
32812.5
P.V@12%
29296.88
26157.92
23355.29
20852.94
NPV of tax shield
99663.03
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