Question

Question: The Summit Petroleum Corporation will purchase an asset that qualifies for three-year MACRS depreciation. The cost is \(160,000 and the asset will provide the following stream of earnings before depreciation and taxes for the next four years:

Year 1	\)70,000
Year 2	85,000
Year 3	42,000
Year 4	40,000

The firm is in a 35 percent tax bracket and has an 8 percent cost of capital. Should it purchase the asset? Use the net present value method.

Short answer

Answer

The net present value is positive. Therefore,the business entity must purchase the asset.

Step-by-step solution

Definition of Capital Budgeting

Capital budgeting can be defined as the process by which the investors assess the different available investment options. It includes methods such as the payback method, Net present value, and IRR.

Investment decision

Calculation of depreciation

Year	Depreciation base	MACRS rate	Depreciation
1	$160,000	0.333	$53,280
2	160,000	0.445	$71,200
3	160,000	0.148	$23,680
4	160,000	0.074	$11,840
Total			$160,000

Calculation of cash flow during each year:

Particular	Year 1	Year 2	Year 3	Year 4
Earnings before depreciation and tax	$180,000	$180,000	$180,000	$180,000
Depreciation	(53,280)	(71,200)	(23,680)	(11,840)
Earnings before tax	$126,720	$108,800	$156,320	$168,160
Taxes @35%	(44,352)	(38,080)	(54,712)	(58,856)
Earnings after tax	$82,368	$70,720	$101,608	$109,304
Depreciation	53,280	71,200	23,680	11,840
Cash flow	$135,648	$141,920	$125,288	$121,144

Calculation of net present value:

Year	Cash inflows	PVIF @ 8%	Present value
1	$135,648	0.926	$125,610
2	$141,920	0.857	$121,625
3	$125,288	0.794	$99,479
4	$121,144	0.735	$89,041
Total present value of cash inflows	$435,755
Less: initial investment	(160,000)
Net present value	$275,755