Kristin is evaluating a capital budgeting project that should last for 4 years.
ID: 2699335 • Letter: K
Question
Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $875,000 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%.
How much higher would the NPV be under the preferred method? Round your answer to two decimal places.
Explanation / Answer
Under MACRS method
Depriciation year 1 = 875000 * 0.33 = 288750
Depriciation year 2 = 875000 * 0.45 = 393750
Depriciation year 3 = 875000 * 0.15 =131250
Depriciation year 4 = 875000 * 0.07 =61250
after cash flow of year 1 = 288750 * 0.40 = 115500
after cash flow of year 2 = 393750 * 0.40 = 157500
after cash flow of year 3 = 131250 * 0.40 = 52500
after cash flow of year 4 = 61250 * 0.40 = 24500
NPV = -875000 + 115500/(1+0.12) + 157500/(1+0.12)^2 + 52500/(1+0.12)^3 + 24500/(1+0.12)^4 = -593378.308
UNDER STRAIGH_LINE DEPRICIATION METHOD
Depriciation for every year = 875000/4 = 218750
After tax cash flow of every year = 218750 * 0.4 = 87500
NPV = -875000 + 87500/(1+0.12)+ 87500/(1+0.12)^2 + 87500/(1+0.12)^3+ 87500/(1+0.12)^4 = -609231.932
NPV would be higher under MACRS method by 15853.624 (-593378.308 - (-609231.932))
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