A project has an initial cost of $40,000, expected net cash inflows of $9,000 per year for 7 years, and a cost of capital of 1%. What is the project's NPV?
Replacement Analysis
Although the Chen Company's milling machine is old, it is still in relatively good working order and would last for another 10 years. It is inefficient compared to modern standards, though, and so the company is considering replacing it. The new milling machine, at a cost of $110,000 delivered and installed, would also last for 10 years and would produce after-tax cash flows9labor savings and depreciation tax savings) of 19,0000 per year. It would have zero salvage value at the end of its life. The firm's WACC is 10%, and its marginal tax rate is 35%. Should Chen buy the new machine?
Depreciation Methods
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 ill last 4 years and requires $1,700,000 of equipment. The company could use 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 MACRS 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 deprecation method would produce the higher NPV, and how much higher would it be?
c. Why might Wendy's boss prefer straight-line depreciation?
Discuss the major capital budget methods used by corporations to evaluate projects. Why do many corporations continue to use the payback method? Which do you prefer? Explain why you prefer this method.