NewCom Corporation is considering the purchase of a private jet that will be used primarily for transporting senior executives to remote project sites around the world. The jet will also be available for rental by other organizations when not in use by company personnel. Newcom’s CFO, Bill Spender, has completed a preliminary calculation that shows a negative NPV based on assumptions that include straight-line depreciation of the $17 million jet over its estimated useful live of 5 years and assuming a salvage value of 2 million. Bill asks the company controller,Kay Broma, to review his assumptions and calculations in the hopes that he is missing something that might allow him to present a positive result to the CEO who is planning to ask for board approval for the purchase at their upcoming meeting. Kay immediately mentions to Bill the tax benefits available under MACRS depreciation that would positively impact the projected after-tax cash flows in the early years of the project and might possibly make the NPV a positive number. Bill asks Kay to complete her analysis as soon as possible and report back to him with the revised project NPV. Kay uses the following additional information to complete her updated analysis ( millions): Risk-adjusted discount rate: 10% Effective tax rate: 40% MACRS asset class* 5-yr property MACRS recovery %* 20%, 32%, 19%, 12%, 12%, 5% * The asset class and recovery percentages indicated are for demonstration purposes only and are not intended to reflect the actual values that would apply via the current U.S. tax laws. The MACRS first year recovery rate reflects a “half-year” convention that assumes the asset is placed into service mid-year. Initial Cash Flow (CF0): Purchase of jet $17.0 Increase in working capital 0.5 Total initial outlay $17.5 Incremental Cash Flows for years 1 through 5(CF1-5): Annual Operating Cash Flows = Ä Operating Expenses (1-t) + Ä Depreciation (t) CF 1 – 5 = $4.9** (0.6) + $3.0(0.4) = $4.14 **Reflects travel cost savings including rental income, net of jet operating costs. Terminal year (CFT): Salvage value of jet $2.0 Tax from gain on sale 0.0*** Recovery of net WC 0.5 CFT $2.5 ***There is no gain on the sale as the estimated salvage value of $2.0 million is equal to the book value at the end of year 5 ($17 million cost - 15 million depreciation). The revised NPV calculation performed by Broma is closest to: a. (1,278,700) b. (143,400) c. (12,000)
Where does the 3.0 for depreciation come from? What I did was take the operating cost savings and added the tax savings from depreciation of the $17 capital expenditure in accordance to the MACRS schedule. Doesn’t seem to be right
the 3 would’ve been straight line- 17 mil, 2 mil salvage, so 15 over 5 yrs, 3 a year. i’m playing with these #'s right now though and not getting any of the answers. need to keep playing.
right, stupid me. Yeah, I eliminated that depreciation and added the MACRS, I’m trying to do it without paper 
OK, I figured it out I think. Apply the MACRS to 15 million not 17 million (duh again)
is it b? 143400 (-ve) Are cash flows as 4.14, 4.86, 4.12, 3.66, 3.66, 3.24+2.5 but using this gives me a +ve npv or 4.14, 4.86, 4.12, 3.66, 3.66 + 2.5 this gives me a -ve cf of 299.7K not sure what is going on here.
yeah i’m doing that but not getting a good answer. MACRS recovery %* 20%, 32%, 19%, 12%, 12%, 5% says 1st one is mid-year, so i don’t know whether i’m supposed to average these #'s or just start using them. i’m thinking do something like the 4.9(.6) + let’s say we used 20% for year 1, then it’d be the same 4.14 as the answer. if i instead let’s say averaged out the 20 and 32% for year 1, i got 4.5 is my CF1. and the CF’s go down by the years… but still i’m not getting the right answer. UGH. CFO and the terminal CF here aren’t changing at all, are they? i know i’m doing something really stupid here. help meeeeeeeeee.
calculated cash flows as follows depr for each year: 1.2, 4.8, 2.85, 1.8, 1.8, .75 take 40% of above add to 60% of 4.9
CP- those are the #'s i got at 1st for all of the year’s CF’s but i didn’t get an answer, so i tried to tweak it and average the MACRS #'s since they give 6 and i have 5 yrs… still no dice. something is funny here.
The MACRS depreciation still has 5% bv left over at the end of 5 years. so if this were a 5 year thingie - the book value is .75, fair value = salvage value = 2 mill - so there is a gain of 1.25 million there. so wouldn’t that cause a capital gains tax of 0.5 million to be subtracted?
phil just sent me the answer, under MACRS, you assume that the salvage value given is not correct so you incur a capital gain. cp correct. Tax on gain is (17 - (17-16.15)*0.4
so what are the CF’s then? CFO = -17.5 CF1 = 4.14 CF2 = 4.86 CF3 = 4.08 CF4 = 3.66 CF5 = ? those other ones right? walk me through this last one.
yeah c is the answer - - here it is below, a bit jumbled though Choice “c” is correct. The first step is to calculate the Year 1 - Year 5 cash flows using MACRS depreciation as follows: (A) (B) (A) + (B) Year OE(1-t) MACRS(1) MACRS(t) CF 1 $2.94 $3.40 $1.36 $4.30 2 2.94 5.44 2.18 5.12 3 2.94 3.23 1.29 4.23 4 2.94 2.04 0.82 3.76 5 2.94 2.04 0.82 3.76 Totals $16.15 (1) MACRS Depreciation is calculated by multiplying the asset cost of $17 million times the recovery % given in the fact situation. Note that the first year rate reflects the “half-year” convention used under MACRS. 20% is 1/2 of the depreciation rate used under the double-declining-balance method (2 / 5 = 40%). Also note that salvage value is not a consideration under MACRS as the asset is depreciated to $0 if held for six years. Next, the revised terminal cash flow calculated as follows: Salvage value of jet $2.00 Tax from gain on sale [($2 - ($17-16.15)) x 40%] -0.46 Recovery of net WC 0.50 CFT $2.04 The revised NPV can then be calculated as follows: 1 2 3 4 5 4.30 5.12 4.23 3.76 3.76 2.04 NPV $17.5 (1.10) (1.10) (1.10) (1.10) (1.10) $0.01197 million $12,000 + = − + + + + + = − ¡Ö − It turns out that the use of MACRS depreciation was not enough to make the NPV of the project positive. In this case, the increase in the after-tax cash flows from the accelerated depreciation was offset by the effect of the terminal cash flow resulting from the gain on the sale under MACRS. Choice “a” is incorrect. This choice ignores the terminal cash flows in calculating the revised NPV. Choice “b” is incorrect. This choice incorrectly uses salvage value in calculating MACRS depreciation.
wow. this is stalla? they aren’t f’ing around. this was great though. i didn’t know that for MACRS you took the actual value (the 17) and not the depreciable value of the 15 that we use in the straight line - salvage. so you for MACRS use the straight value, multiply it by the %'s to get your CF’s, and then just work out the gain/loss part at the end in your final cash flow. cool- that answer makes sense, just banged it through my calculator and it worked. i’m exhausted. solid day team. thx for posting that toughie.