Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $300,000, and it would cost another $60,000 to modify the equipment for special use by the firm. The equipment falls into the MACRS 3-year class and would be sold after 3 years for $90,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $13,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $40,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.

1. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent. Negative amount should be indicated by a minus sign.
   $

2. What are the project's annual cash flows in Years 1, 2, and 3? Round your answers to the nearest cent.

   In Year 1 $

   In Year 2 $

   In Year 3 $

3. If the WACC is 10%, should the spectrometer be purchased?
   -Select-YesNoItem 5

Answer 1

a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital

= -300,000-60,000-13,000

= -$373,000

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	40,000	40,000	40,000
Less: Depreciation	118,800	162,000	54,000
Net Savings	-78,800	-122,000	-14,000
Less: Tax @40%	-31,520.00	-48,800.00	-5,600.00
Income after Tax	-47,280.00	-73,200.00	-8,400.00
Add: Depreciation	118,800	162,000	54,000
Cash Flow	71,520.00	88,800.00	45,600.00
Add: After tax salvage value			64,080.00
Recovery of Working capital			13,000
Cash Flow	71,520.00	88,800.00	122,680

Note: Written down value of machine = 360,000*7% = $25,200

Sale Price = $90,000

Gain on Sale = $64,800

Tax on Gain = $25,920

After tax salvage value = 90,000 – 25,920 = $64,080

c.NPV = Present value of cash inflows – present value of cash outflows

= 71,520*PVF(10%, 1 year) + 88,800*PVF(10%, 2 years) + 122,680*PVF(10%, 3 years) – 373,000

= 71,520*0.909 + 88,800*0.826 + 122,680*0.751 – 373,000

= -$142,506.84

No, should not be purchased (since NPV is negative)