5.Depreciation methods

Sam is evaluating a capital budgeting project that should last for four years. The project requires $700,000 of equipment. He is unsure what depreciation method to use in her analysis, straight-line or the three-year MACRS accelerated method. Under straight-line depreciation, the cost of the equipment would be depreciated evenly over its four-year life (ignore the half-year convention for the straight-line method). The applicable MACRS depreciation rates are 33.33, 44.45, 14.81 and 7.41 percent. Assume that both straight-line and MACRS depreciation expenses begin in Year 1.

The company's required return on capital is 10%and its tax rate is 40%.

a.What would the depreciation expense be each year under each method?

b.Calculate the PV of the depreciation tax shield for both straight-line and MACRS. Which depreciation method produces the higher value? By how much?

4 A) 5 Project Cost $ 700,000 6 MACRS 7 Year Rate Depreciation Cost Less Depreciation 33% $ 233,310 $ 466,690 W N 44% $ 311,150 155,540 10 15% $ 103,670 51,870 11 4 7.41% $ 51,870 12 13 Straight Line Depreciation $ 175,000 14 B) 15 Tax Shield MACRS & PV 16 Year Depreciation Tax Rate @ 40% PVF @ 10% PV 17 1 $ 233,310 $ 93,324 0.909 18 2 $ 311,150 124,460 0.826 19 3 103,670 41,468 0.751 20 4 $ 51,870 20,748 0.683 21 22 Tax Shield Straight Line Method & PV 23 Year Depreciation Tax Rate @ 40% PVF @ 10% PV 24 1 $ 175,000 $ 70,000 0.909 25 2 S 175,000 70,000 0.826 26 3 S 175,000 $ 70,000 0.751 27 4 S 175,000 S 70,000 0.683