Question

G.S corp. is considering a tractor that would have a cost of $36,000, would increase pretax 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 service manager then states that some last for as long as 8 years.
Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractors 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 5-year straight-line depreciation for all analyses and ignore the MACR half-year convention for this problem.

Answer 1

Depreciation tax shield in Years 1 to 5 = depreciation amount * tax rate = $7200 * 40% = $2880.

Increase in pretax cash flow (after depreciation) = Increase in pretax cash flow (before depreciation) + depreciation tax shield.

Increase in after-tax cash flow =Increase in pretax cash flow (after depreciation) - taxes

5-year life

NPV is calculated using NPV function in Excel

NPV is -$2,156

6-year life

The depreciation tax shield is only for 5 years. Hence, from this year onwards, there is no depreciation tax shield.

NPV is calculated using NPV function in Excel

NPV is $1,908

7-year life

The depreciation tax shield is only for 5 years.  

NPV is calculated using NPV function in Excel

NPV is $5,603

8-year life

NPV is calculated using NPV function in Excel

NPV is $8,962