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Studying the Effect of the Depreciation Method on NPV

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Wendy's boss wants to use straight-line depreciation for the new expansion project because he said it will give higher net income in earlier years and give him a larger bonus. The project will last 4 years and requires$1,700,000 of equipment. The company could either straight line or the 3-year MACRS accelerated method. Under straight line depreciation the cost of the equipment would be depreciated evenly over its 4-year life(ignore the half-year convention for the straight line method). The applicable MARCS depreciation rates are 33.33%, 44.45%, 14.81%, and 7.41%. The company's WACC is 10% and its tax rate is 40%.
a. What would the depreciation expense be each year under each method?
b. Which depreciation method would produce the higher NPV, and how much higher would it be?

That is the question I am working on. What I am having trouble with is part b.

- Why might Wend's boss prefer straight line depreciation?

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Solution Summary

This solution studies the effect of the depreciation method used on the NPV of a project. The solution is provided within an Excel document which is attached.

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To Hot to Handle: Case Study - Capital Budgeting

See the case file attached.

Exhibit 1 Some Relevant Information
Salon Hours: Sunday, Monday Closed
Tues-Thurs 9am - 7pm
Fri 9am - 5pm
Sat 9am - 2pm
Advertising Costs $300 per month (Yellow Pages Ad)
$200 per month (other advertisements)
Patsy's After-tax cost of funds: 11% per year
Depreciation method: Straight line over 5 yrs.
Tax rate: 30%

Cost (including shipping) $7800 $2800
Set up cost $500 $200
Electricity cost per session $0.50 $0.30
Number of sessions/hour 4 3
Number of bulbs needed 48 28
Cost per bulb $22 $22
Bulb life 1300 hours 1300 hours
Unit life 8 years 5 years
Suggested price/visit $3 $3
Space requirement +
9 ft X 5ft X 5ft room 10 ft X 10 ft room

Other income
Tanning Lotion 1 bottle/10 sessions
Profit per sale $5
Questions 1-7:

1. Develop operating cash flow forecasts for the relevant lives of each type of tanning equipment using 100% (Best case), 80% (Most Likely Case), and 50% (Worst Case) occupancy estimates for each tanning option. Assume straight line depreciation and a tax rate of 30%.

2. Calculate and comment upon the accounting, cash, and financial break-even sales for the dome unit and the tanning bed unit respectively.

3. Calculate the net present value, payback period, and the traditional IRR for each tanning option under the various scenarios. What do the decision rules indicate?

4. Can Patsy evaluate this business project by assuming just a onetime purchase? Why or why not? What other evaluation methods should Patsy use?

5. If you decide to use the replacement chain method, how do the calculation and decision change?

6. What are some externalities, side effects, and other relevant issues that could affect the decision?

7. Based upon your analysis, which of the two units is "Too Hot to Handle?" Why?

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