Chapter 12, Problem 18P

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15th Edition

Eugene F. Brigham + 1 other

ISBN: 9781337395250

Textbook Problem

**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 straight-line 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.

Assume that if the tractor only lasts 4 years, then the firm would receive a tax credit in Year 4 because the tractor’s salvage value at the time is less than its book value. Under this scenario, the firm would not take depreciation expense in Year 5.

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 10% WACC. Assuming each of the indicated lives has the same probability of occurring (probability = 1/3), what is the tractor's expected NPV?

Summary Introduction

**To Determine:** The expected NPV of the tractor.

**Introduction:** The net present value is also termed as the discounted cash flow approach is a mainstream capital budget method that considers the time value of cash. It utilizes net present value of the investment as the base to accept or reject a projected investment in projects like buying of new machine, buying of stock or inventory etc.

Explanation

**Determine the net present value of the tractor if the life is 5 years using the time line approach**

Using a excel spreadsheet, the net present value of the tractor if the life is 5 years utilising the time line approach is determined as $2,211.13

**Excel Spreadsheet:**

**Excel Workings:**

**Therefore the net present value of the tractor if the life is 5 years using the time line approach is $2,211.13.**

**Determine the net present value of the tractor if the life is 4 years using the time line approach**

Using a excel spreadsheet, the net present value of the tractor if the life is 4 years using the time line approach is determined as -$2,080.68

**Excel Spreadsheet:**

**Excel Workings:**

**Therefore the net present value of the tractor if the life is 4 years using the time line approach is -$2,080.68.**

**Determine the net present value of the tractor if the life is 8 years using the time line approach**

Using a excel spreadsheet, the net present value of the tractor if the life is 8 years using the time line approach is determined as $13,328.93

**Excel Spreadsheet:**

**Excel Workings:**

**Therefore the net present value of the tractor if the life is 8 years using the time line approach is $13,328.93.**

**Determine the expected NPV**

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