Your firm, Agrico Products, is considering a tractor that wouldhave a cost of $36,000, would increase pretax operating cash flows before taking account ofdepreciation by $12,000 per year, and would be depreciated on a straight-line basis to zeroover 5 years at the rate of $7,200 per year beginning the first year. (Thus, annual cash flowswould 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 controller insiststhat she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller,but he argues that most tractors do give 5 years of service. The service manager thenstates that some last for as long as 8 years.Assume that if the tractor only lasts 4 years, then the firm would receive a tax credit inYear 4 because the tractor’s salvage value at the time is less than its book value. Under thisscenario, the firm would not take depreciation expense in Year 5.Given this discussion, the CFO asks you to prepare a scenario analysis to determinethe importance of the tractor’s life on the NPV. Use a 40% marginal federal-plus-state taxrate, a zero salvage value, and a 10% WACC. Assuming each of the indicated lives has thesame probability of occurring (probability =1/3), what is the tractor’s expected NPV?
Your firm, Agrico Products, is considering a tractor that would
have a cost of $36,000, would increase pretax operating cash flows before taking account of
depreciation by $12,000 per year, and would be
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 controller insists
that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller,
but he argues that most tractors do give 5 years of service. The
states that some last for as long as 8 years.
Assume that if the tractor only lasts 4 years, then the firm would receive a tax credit in
Year 4 because the tractor’s salvage value at the time is less than its book value. Under this
scenario, the firm would not take depreciation expense in Year 5.
Given this discussion, the CFO asks you to prepare a scenario analysis to determine
the importance of the tractor’s life on the
rate, a zero salvage value, and a 10% WACC. Assuming each of the indicated lives has the
same probability of occurring (probability =1/3), what is the tractor’s expected NPV?
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