Question

NEW PROJECT ANALYSIS

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $250,000, and it would cost another $50,000 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 $125,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $15,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $31,000 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 12%, should the spectrometer be purchased?
   -Select-Yes / No

Answer 1

Initial Investment = Base Price + Modification Cost
Initial Investment = $250,000 + $50,000
Initial Investment = $300,000

Useful Life = 3 years

Depreciation Year 1 = 33% * $300,000
Depreciation Year 1 = $99,000

Depreciation Year 2 = 45% * $300,000
Depreciation Year 2 = $135,000

Depreciation Year 3 = 15% * $300,000
Depreciation Year 3 = $45,000

Book Value at the end of Year 3 = $300,000 - $99,000 - $135,000 - $45,000
Book Value at the end of Year 3 = $21,000

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $125,000 - ($125,000 - $21,000) * 0.40
After-tax Salvage Value = $83,400

Initial Investment in NWC = $15,000

Answer a.

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$300,000 - $15,000
Net Cash Flows = -$315,000

Answer b.

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $31,000 * (1 - 0.40) + 0.40 * $99,000
Operating Cash Flow = $58,200

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $58,200

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $31,000 * (1 - 0.40) + 0.40 * $135,000
Operating Cash Flow = $72,600

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $72,600

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $31,000 * (1 - 0.40) + 0.40 * $45,000
Operating Cash Flow = $36,600

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $36,600 + $15,000 + $83,400
Net Cash Flows = $135,000

Answer c.

Required Return = 12%

NPV = -$315,000 + $58,200/1.12 + $72,600/1.12^2 + $135,000/1.12^3
NPV = -$109,069

NPV of the spectrometer is negative. So, it should not be purchased.