Wendy is evaluating a capital budgeting project that should last for 4 years. Th

Question

Wendy is evaluating a capital budgeting project that should last for 4 years. The project requires $700,000 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 9%, and its tax rate is 40%. a.What would the depreciation expense be each year under each method? Year 1 Scenario 1 (Straight Line) year 1 $ 2 $ 3 $ 4 $ Scenario 2 (MACRS) year 1 $ 2 $ 3 $ 4 $ b.Which depreciation method would produce the higher NPV? Scenario 1Scenario 2 ? C How much higher would it be? Round your answer to the nearest dollar.

Explanation / Answer

Hi, Please find the answers as follows: Part A Depreciation under Straight-Line = 700000/4 = 175000 for each year Depreciation under Accelerated Method: Year 1 = 700000*.33 = 231000 Year 2 = 700000*.45 = 315000 Year 3 = 700000*.15 = 105000 Year 4 = 700000*.07 = 49000 Part B Depreciation Expense Difference Accelerated - SLM Year 1 = 231000 - 175000 = 56000*.4 = 22400 Year 2 = 315000 - 175000 = 140000*.4 = 56000 Year 3 = 105000 - 175000 = -70000*.4 = -28000 Year 4 = 49000 - 175000 = -126000*.4 = -50400 NPV = 22400/(1+.09)^1 + 56000/(1+.09)^2 -28000/(1+.09)^3 - 50400/(1+.09)^4 = 10358.77 Going by the above calculations, the accelerated depreciation method will give a higher NPV by 10358.77 as compared to straight-line depreciation method. Thanks.

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