Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $110,000, and it would cost another $16,500 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 $33,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $7,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $36,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%. 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. $ 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 $ If the WACC is 13%, should the spectrometer be purchased?

Answer 1

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

= 110,000+16,500 +7,000

= -$133,500 since outflow

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	36,000	36,000	36,000
Less: Depreciation	41,745	56,925	18,975
Net Savings	-5,745	-20,925	17,025
Less: Tax @40%	-2,298.00	-8,370.00	6,810
Income after Tax	-3447.00	-12,555.00	10,215.00
Add: Depreciation	41,745.00	56,925.00	18,975.00
Cash Flow	38,298.00	44,370.00	29,190.00
Add: After tax salvage value			23,342.00
Recovery of Working capital			7,000
Cash Flow	38,298.00	44,370.00	59,532.00

Note: Written down value of machine = 126,500*7% = $8,855

Sale Price = $33,000

Gain on Sale = $24,145

Tax on Gain = $9,658

After tax salvage value = 33,000– 9,658 = $23,342

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

= 38,298*PVF(13%, 1 year) + 44,370*PVF(13%, 2 years) + 59,532*PVF(13%, 3 years) – 133,500

= 38,298*0.885 + 44,370*0.773+ 59,532*0.693 – 133,500

= -$23,167.584

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