Question

G.S corp. is considering purchasing a tractor that has a cost of $36,000, would increase pre-tax cash flows by $12,000 before accounting for depreciation, 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. Assume each of the indicated lives has the same 5-year straight-line depreciation for all analyses. Ignore the MACR half-year convention for this problem.

Answer 1

5-Year life-depn.=36000/5=7200
Initial cost	-36000
PV of After-tax annual cash flows(12000*(1-40%))=7200
P/A,7200,10%,5	27294
7200*3.79079
Depn. Tax shields(7200*40%)=2880
P/A,2880,10%,5	10917
2880*3.79079
NPV	2211
8-Year life-depn.=36000/8=4500
Initial cost	-36000
PV of After-tax annual cash flows(12000*(1-40%))=7200
P/A,7200,10%,8	38411
7200*5.33493
Depn. Tax shields(4500*40%)=1800
P/A,1800,10%,8	9603
1800*5.33493
NPV	12014
	NPV
5-year life of tractor	2211
8 year life of tractor	12014