SCENARIO ANALYSIS Your firm, Agrico Products, is considering a tractor that would have a cost of $36,000, would increase pretax operating cash flows before taking account of depreciation by $12,000 per year, and would be depreciated on a straightline basis to zero over 5 years at the rate of $7,200 per year beginning the first year. (Thus, annual cash flows would be $12,000 before taxes plus the tax savings that result from $7,200 of depreciation.) The managers disagree about whether the tractor would 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 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 federalplusstate tax rate, a zero salvage value, and a 10% 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 5year straightline depreciation for all analyses, and ignore the MACRS halfyear convention for this problem.)
To prepare: Scenario analysis and tractor’s expected NPV.
Introduction:
Scenario Analysis:
Under this analysis, the management considers the different alternatives outcome to analyze the future events. It is the method in which the analyst estimates the expected future value after a period of time.
Net present Value (NPV):
NPV is the technique of capital budgeting. It is used to decide whether to accept or reject a project. If the project has positive NPV then accept the project, if the NPV is negative then reject the project.
Given information:
Tractor cost is $36,000.
It increase the pretax operating cash flows by $12,000 per year.
Straight line method of depreciation follows
Life is 5 years and depreciation is $7,200 per year
Controller thinks that the life of tractor is 4 years
Tax rate 40%
Weighted average cost of capital is 10%
Prepare table that shows the calculation of expected NPV.
Life of tractor (Years)  Probability of outcome (A) 
NPV ($) (B) 
Expected NPV (C)

5  0.33  36,768  12,133.44 
4  0.33  24,864  8205.12 
8  0.34  66,336  22,554.24 
Table (1)
Where the life of tractor is 5 years
Formula to calculate net present value is,
Substitute $72,768 for present value of cash inflow and $36,000 for present value of cash outflow.
Where the life of tractor is 4 years
Formula to calculate net present value is,
Substitute $60,864 for present value of cash inflow and $36,000 for present value of cash outflow.
Where the life of tractor is 8 years
Formula to calculate net present value is,
Substitute $102,336 for present value of cash inflow and $36,000 for present value of cash outflow
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