Charlene is evaluating a capital budgeting project that should last for 4 years.

Question

Charlene is evaluating a capital budgeting project that should last for 4 years. The project requires $575,000 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 10%, and its tax rate is 35%. What would the depreciation expense be each year under each method? I have gotten this part already, correct answers below:

Scenario 1 (Straight-Line) Scenario 2 (MACRS)

1. 143,750 1. 189,750

2. 143,750 2. 258,750

3. 143,750 3. 86,250

4. 143,750 4. 40,250

Which depreciation method would produce the higher NPV? MACRS

Explanation / Answer

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A B C D 1 2 3 4 1 Depreciation using straight line method 143750 143750 143750 143750 (Initial Investment-0)/4 2 Depreciation Tax shield 50312.5 50312.5 50312.5 50312.5 Depreciation tax Shield = Depreciation * Tax rate 3 WACC 10% NPV $159,483.86 NPV(A3,A2:D2) Initial Investment 575000 A B C D 1 2 3 4 1 Depreciation rate using MACRS 33% 45% 15% 7% 2 Depreciation = Depreciation rate * Initial Investment 189750 258750 86250 40250 3 WACC 10% NPV $478,635.17 NPV(A3,A2:D2) NPV of MACRS is greater than straightline method by $319,151.31 NPV of MACRS - NPV of Starighline depreciation

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