Question

Manning Corporation is considering a new project requiring a \(90,000 investment in test equipment with no salvage value. The project would produce \)66,000 of pretax income before depreciation at the end of each of the next six years. The company’s income tax rate is 40%. In compiling its tax return and computing its income tax payments, the company can choose between the two alternative depreciation schedules shown in the table.

Straight-Line MACRS

Depreciation Depreciation*

Year 1 . . . . . . . . . . \( 9,000 \)18,000

Year 2 . . . . . . . . . . 18,000 28,800

Year 3 . . . . . . . . . . 18,000 17,280

Year 4 . . . . . . . . . . 18,000 10,368

Year 5 . . . . . . . . . . 18,000 10,368

Year 6 . . . . . . . . . . 9,000 5,184

Totals . . . . . . . . . . . \(90,000 \)90,000

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) straight-line depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the amount of income before depreciation minus the income taxes. (Round answers to the nearest dollar.)

2. Prepare a five-column table that reports amounts (assuming use of MACRS depreciation) for each of the following for each of the six years: (a) pretax income before depreciation, (b) MACRS depreciation expense, (c) taxable income, (d) income taxes, and (e) net cash flow. Net cash flow equals the income amount before depreciation minus the income taxes. (Round answers to the nearest dollar.)

3. Compute the net present value of the investment if straight-line depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

4. Compute the net present value of the investment if MACRS depreciation is used. Use 10% as the discount rate. (Round the net present value to the nearest dollar.)

Analysis Component

5. Explain why the MACRS depreciation method increases this project’s net present value.

Short answer

The net cash flows are computed using both methods. The NPV using a straight line is $108,518 and NPV using MACRS is $110,303. MACRS shows an increased NPV because of the increased cash inflows.

Step-by-step solution

Step-by-Step SolutionStep 1: Preparation of table using straight-line depreciation

Year	Income before depreciation	Straight-line depreciation	Taxable Income	Income Taxes	Net Cashflows
Year 1	$66,000	$9,000	$57,000	$22,800	43,200
Year 2	66,000	18,000	48,000	19,200	46,800
Year 3	66,000	18,000	48,000	19,200	46,800
Year 4	66,000	18,000	48,000	19,200	46,800
Year 5	66,000	18,000	48,000	19,200	46,800
Year 6	66,000	9,000	57,000	22,800	43,200

Preparation of table using MACRS depreciation

Year	Income before depreciation	Straight-line depreciation	Taxable Income	Income Taxes	Net Cashflows
Year 1	$66,000	$18,000	$48,000	$19,200	$46,800
Tear 2	66,000	28,800	37,200	14,880	51,120
Year 3	66,000	17,280	48,720	19,488	46,512
Year 4	66,000	10,368	55,632	22,253	43,747
Year 5	66,000	10,368	55,632	22,253	43,747
Year 6	66,000	5,184	60,816	24,326	41,674

Computation of net present value (Straight-line method)

Charts Values are based on:
	I = 10%
Year	Net Cash Inflow	X	PV Factor	=	Present Value
1	43,200	X	0.9091	=	39,273
2	46,800	X	0.8264	=	38,676
3	46,800	X	0.7513	=	35,161
4	46,800	X	0.6830	=	31,964
5	46,800	X	0.6209	=	29,058
6	43,200	X	0.5645	=	24,386

Present Value of cash inflows	$198,518
Present Value of cash outflows	-90,000
Net present value	$108,518

Computation of net present value (MACRS)

Charts Values are based on:
	I = 10%
Year	Net Cash Inflow	X	PV Factor	=	Present Value
1	46,800	X	0.9091	=	42,546
2	51,120	X	0.8264	=	42,246
3	46,512	X	0.7513	=	34,944
4	43,747	X	0.6830	=	29,879
5	43,747	X	0.6209	=	27,163
6	41,674	X	0.5645	=	23,525
Present Value of cash inflows					$200,303
Present Value of cash outflows					-90,000
Net present value					$110,303

MACRS depreciation increases the NPV of the project

The MACRS depreciation method increases the net present value of the project as shows higher depreciation in the early years which leads to an increase in the cash inflows. So, MACRS depreciation increases the NPV of the project.