Uncle Elmo is contemplating a $10,000 investment in a methane gas generator. He estimates his gross income would be $2000 the first year and increase by $200 each year over the next 10 years. His expenses of $200 the first year would increase by $200 each year over the next 10 years. He would depreciate the generator by MACRS depreciation, assuming a 7-year property class. A 10-year-old methane generator has no market value. The income tax rate is 40%. (Remember that recaptured depreciation is taxed at the same 40% rate.)
(a) Construct the after-tax cash flow for the 10-year project life.
(b) Determine the after-tax rate of return on this investment. Uncle Elmo thinks it should be at least 8%. (c) If Uncle Elmo could sell the generator for $7000 at the end of the fifth year, would his rate of return be better than if he kept the generator for 10 years? You don't have to actually find the rate of return, just do enough calculations to see whether it is higher than that of part (b).