Scenario Analysis:
Your firm, Agrico Products, is considering the purchase of a tractor that will have a net cost of $36,000, will increase pre-tax operating cash flows before taking account of depreciation effects by $12,000 per year, and will be depreciated on a straight-line basis over 5 years at the rate of $7,200 per year, beginning the first year. (Annual cash flows will be $12,000, before taxes, plus the tax savings that result from $7,200 of depreciation.) The board of directors is having a heated debate about whether the tractor will actually last 5 years. Specifically, Elizabeth Brannigan insists that she knows of some tractors that have lasted only 4 years. Philip Glasgo agrees with Brannigan, but he argues that most tractors do give 5 years of service. Laura Evans says she has known some to last for as long as 8 years.
Given this discussion, the board asks you to prepare a scenario analysis to ascertain the importance of the uncertainty about the tractor's life. Assume a 40% marginal federal-plus-state tax rate, a zero salvage value, and a cost of capital of 10%. (Hint: Here straight-line depreciation is based on the MACRS class life of the tractor and is not affected by the actual life. Also, ignore the half-year convention for this problem).