Your firm, Agrico Products, is considering a tractor that would have a cost of $

Question

Your firm, Agrico Products, is considering a tractor that would have a cost of $37,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of $7,400 per year, beginning the first year.  (Thus, annual cash flows would be $12,000 before taxes plus the tax savings that result from $7,400 of depreciation.)  The managers are having a heated debate about whether the tractor would actually last 5 years.  The controller insists that she knows of tractors that have lasted only 4 years.  The treasurer agrees with the controller, but he argues that most tractors actually do give 5 years of service.  The service manager then states that some last for as long as 8 years.

Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractor's life on the NPV.   Use a 40% marginal federal-plus-state tax rate, a zero salvage value, and a 8% WACC.  Assuming each of the indicated lives has the same probability of occurring (probability = 1/3), what is the tractor's expected NPV?  (Hint: Use the 5-year straight-line depreciation for all analyses and ignore the MACRS half-year convention for this problem.)

Round your answers to two decimal places. Do not round intermediate calculations.

Tractor's NPV if actual life is 4 years.

$

Tractor's NPV if actual life is 8 years.

$

Tractor's expected NPV.

$

ANSWERS AND DETAILS.

Explanation / Answer

A

B

C

EXPECTED NPV = 1/3*NPV OF 4 YEARS + 1/3*NPV OF 8 YEARS + 1/3*NPV OF 5 YEARS
= 1/3*-3348.79 + 1/3*16194.22 + 1/3*3565.93
= $5470.45

PARTICULARS/YEAR 0 1 2 3 4 Initial Investment -37000 Salvage Value Increase in PreTax Operating Cashflow 12000 12000 12000 12000 (-) Depreciation -7400 -7400 -7400 -7400 EBIT 4600 4600 4600 4600 (-) Tax @ 40% -1840 -1840 -1840 -1840 PAT 2760 2760 2760 2760 (+) Depreciation 7400 7400 7400 7400 NET CASH GENERATED -37000 10160 10160 10160 10160 P.V. Factor (8%) 1.0000 0.9259 0.8573 0.7938 0.7350 P.V. of cashflow -37000 9407.407 8710.562 8065.336 7467.903 N.P.V. (16%) -3348.79

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