Question

Grossman Corporation is considering a new project requiring a \(30,000 investment in an asset having no salvage value. The project would produce \)12,000 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 two alternative depreciation schedules as shown in the table.

Straight-Line MACRS

Depreciation Depreciation*

Year 1 . . . . . . . . . . \( 3,000 \)6,000

Year 2 . . . . . . . . . . 6,000 9,600

Year 3 . . . . . . . . . . 6,000 5,760

Year 4 . . . . . . . . . . 6,000 3,456

Year 5 . . . . . . . . . . 6,000 3,456

Year 6 . . . . . . . . . . 2,000 1,728

Totals . . . . . . . . . . . \(30,000 \)30,000

Required

1. Prepare a five-column table that reports amounts (assuming use of straight-line depreciation) for each of the following items 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 items 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 amount of income 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 the net present value of this project.

Short answer

The net cash flows are computed using both methods. The NPV using a straight line is $10,041 and NPV using MACRS is $10,635. 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	$12,000	$3,000	$9,000	$3,600	$8,400
Year 2	12,000	6,000	6,000	2,400	9,600
Year 3	12,000	6,000	6,000	2,400	9,600
Year 4	12,000	6,000	6,000	2,400	9,600
Year 5	12,000	6,000	6,000	2,400	9,600
Year 6	12,000	3,000	9,000	3,600	8,400

Preparation of table using MACRS depreciation

Year	Income before depreciation	Straight-line depreciation	Taxable Income	Income Taxes	Net Cashflows
Year 1	$12,000	$6,000	$6,000	$2,400	$9,600
Tear 2	12,000	9,600	2,400	960	11,040
Year 3	12,000	5,760	6,240	2,496	9,504
Year 4	12,000	3,456	8,544	3,418	8,582
Year 5	12,000	3,456	8,544	3,418	8,582
Year 6	12,000	1,728	10,272	4,109	7,891

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	8,400	X	0.9091	=	7,636
2	9,600	X	0.8264	=	7,933
3	9,600	X	0.7513	=	7,212
4	9,600	X	0.6830	=	6,557
5	9,600	X	0.6209	=	5,961
6	8,400	X	0.5645	=	4,742
Present Value of cash inflows					$40,041
Present Value of cash outflows					-30,000
Net present value					$10,041

Computation of net present value (MACRS)

Charts Values are based on:
	I = 10%
Year	Net Cash Inflow	X	PV Factor	=	Present Value
1	$9,600	X	0.9091	=	8,727
2	11,040	X	0.8264	=	9,123
3	9,504	X	0.7513	=	7,140
4	8,582	X	0.6830	=	5,862
5	8,582	X	0.6209	=	5,329
6	7,891	X	0.5645	=	4,454
Present Value of cash inflows					$40,635
Present Value of cash outflows					-30,000
Net present value					$10,635

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.