Your firm, Agrico Products, is considering the purchase of a tractor that has a net cost of $72,000, will increase pretax operating cash flows before taking account of depreciation effects by $24,000 per year, and will be depreciated on a straight-line basis to $0 over five years at the rate of $14,400 per year, beginning the first year. (Annual cash flows will be $24,000 before taxes plus the tax savings that result from $14,400 of depreciation.) The board of directors is having a heated debate about whether the tractor actually will last five years. Specifically, Joan Lamm insists that she knows of some tractors have lasted only four years. Alan Grunewald agrees with Lamm, but he argues that most tractors do provide five years of service. Judy Maese says she has known some to last for as long as eight years. Given this discussion, the board asks you to prepare a scenario analysis to ascertain the importance of the uncertainty about the tractor’s life span. Assume a 40 percent marginal tax rate, a $0 salvage value, and a required rate of return of 10 percent. (Hint: Here, straight line depreciation is based on the MACRS class life of the tractor and is not affected by the actual life. Also, ignore the half-year convention for this problem.)
Your firm, Agrico Products, is considering the purchase of a tractor that has a net cost of
$72,000, will increase pretax operating cash flows before taking account of
by $24,000 per year, and will be depreciated on a straight-line basis to $0 over five years at the
rate of $14,400 per year, beginning the first year. (Annual cash flows will be $24,000 before
taxes plus the tax savings that result from $14,400 of depreciation.) The board of directors is
having a heated debate about whether the tractor actually will last five years. Specifically, Joan
Lamm insists that she knows of some tractors have lasted only four years. Alan Grunewald
agrees with Lamm, but he argues that most tractors do provide five years of service. Judy Maese
says she has known some to last for as long as eight years.
Given this discussion, the board asks you to prepare a scenario analysis to ascertain the
importance of the uncertainty about the tractor’s life span. Assume a 40 percent marginal tax
rate, a $0 salvage value, and a required
depreciation is based on the MACRS class life of the tractor and is not affected by the actual life.
Also, ignore the half-year convention for this problem.)
Net Present Value:
To determine the current value of a future stream of payments, one uses net present value (NPV).
When capital planning, NPV is used to analyse whether a current investment will result in future positive cash flow.
If a project or investment has a positive net present value (NPV), then all future cash flows linked with it will have positive discounted present values, making it more enticing.
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