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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

DEPRECIATION METHODS Kristin is evaluating a capital budgeting project that should last for 4 years. The project requires $800,000 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% as discussed in Appendix 12A. The company’s WACC is 10%, and its tax rate is 40%.

  1. a. What would the depreciation expense be each year under each method?
  2. b. Which depreciation method would produce the higher NPV, and how much higher would it be?

a.

Summary Introduction

To compute: The depreciation expense of each year and by both the methods.

Depreciation Method:

The method used to calculate the depreciation is called depreciation method; these are generally of two types,

  • Straight line method (SLM)- This method uses three variant; cost of an asset, salvage value and the life of the asset. Depreciation can be computed by dividing the difference of original value of asset and the salvage value by the life of an asset.
  • Modified accelerated cost recovery system (MACRS) - It is another method of calculating the depreciation. This method involves the tax element in the calculation. By this method, the fixed asset of the company divided into sections and then depreciation is computed.

Net present Value (NPV):

NPV is the technique of capital budgeting. To select the project or not depends on the NPV of the project. If the project has positive NPV, then accept the project, if the NPV is negative then reject the project.

Explanation

Given,

Life of project is 4 years.

Cost is $800,000.

Straight line method depreciation computed by taking 4 years life.

The MACRS depreciation rate is 33%in first year, 45% in second year, 15% in third year, and 7% in fourth year.

The weighted average cost of capital (WACC) is 10%.

Tax rate is 40%.

Straight line method

Formula to calculate depreciation is,

Depreciation=Value of equipmentLife of equipment

Substitute $800,000 for value of equipment and 4 years for life of equipment.

Depreciation=$800,0004=$200,000

MACRS

Prepare a table that shows the depreciation,

Year 0 1 2 3 4
Cost of equipment ($800,000)        
Depreciation rate   33% 45% 15% 7%
Depreciation expense   $264,000 $360,000 $120,000 $56,000

Table (1)

Working Notes:

Calculate depreciation through MACRS

b.

Summary Introduction

To compute: The depreciation method that gives the highest NPV.

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