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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

DEPRECIATION METHODS Charlene 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 8%, and its tax rate is 35%.

  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 determine: Depreciation expense of each year using straight line depreciation method and MACRS method.

Introduction:

Straight-line Depreciation:

Straight-line depreciation is the gradual reduction in the value of a fixed asset spread over the period of its working life. The amount of depreciation charged over the asset remains the same until the value of the assets becomes nil.

MACRS:

Modified Accelerated Cost Recovery System (MACRS) of depreciation is the standard method of charging depreciation to an asset for income tax purposes.

Explanation

Given information:

Initial investment is $800,000.

Working life of the equipment is 4 years.

Rate of depreciation under MACRS for year 1 is 33 percent.

Rate of depreciation under MACRS for year 2 is 45 percent.

Rate of depreciation under MACRS for year 3 is 15 percent.

Rate of depreciation under MACRS for year 4 is 7 percent.

Formula to calculate Depreciation expense under straight line method of depreciation is:

Depreciation expense=Value of equpimentLife of equpiment

Substitute $800,000 for life of equipment and 4 for life of equipment,

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b.

Summary Introduction

To determine: The method of depreciation, which produces higher NPV.

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