Question

NEW PROJECT ANALYSIS

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $240,000, and it would cost another $36,000 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 $72,000. 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 $66,000 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 or No

Answer 1

Initial Investment = Base Price + Modification Cost
Initial Investment = $240,000 + $36,000
Initial Investment = $276,000

Useful Life = 3 years

Depreciation Year 1 = 33% * $276,000
Depreciation Year 1 = $91,080

Depreciation Year 2 = 45% * $276,000
Depreciation Year 2 = $124,200

Depreciation Year 3 = 15% * $276,000
Depreciation Year 3 = $41,400

Book Value at the end of Year 3 = $276,000 - $91,080 - $124,200 - $41,400
Book Value at the end of Year 3 = $19,320

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $72,000 - ($72,000 - $19,320) * 0.40
After-tax Salvage Value = $50,928

Initial Investment in NWC = $15,000

Answer a.

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$276,000 - $15,000
Net Cash Flows = -$291,000

Answer b.

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $66,000 * (1 - 0.40) + 0.40 * $91,080
Operating Cash Flow = $76,032

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $76,032

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $66,000 * (1 - 0.40) + 0.40 * $124,200
Operating Cash Flow = $89,280

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $89,280

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $66,000 * (1 - 0.40) + 0.40 * $41,400
Operating Cash Flow = $56,160

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $56,160 + $15,000 + $50,928
Net Cash Flows = $122,088

Answer c.

Required Return = 12%

NPV = -$291,000 + $76,032/1.12 + $89,280/1.12^2 + $122,088/1.12^3
NPV = -$65,041

NPV of the spectrometer is negative, so, the company should not purchase this spectrometer.