Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $270,000, and it would cost another $67,500 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 $67,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $9,000 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%.

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.

Answer 1

Answer

a)

Calculation of initial investment outlay for the Spectrometer-

Base Price- -$270,000

Add-Modification Cost- -$67,500

Add- Increase in net working capital- -$9,000

Total initial investment - -$346,500

b)

Calculation of project annual cash flows-

Particulars	Year 1	Year 2	Year 3
Savings in labor costs	$36,000	$36,000	$36,000
Less- Depreciation on equipment (As per note 1)	-$111,375	-$151,875	-$50,625
Net savings	-$75,375	-$115,875	-$14,625
Tax on net savings @40%	$30,150	$46,350	$5,850
Net savings after tax	-$45,225	$69,525	-$8,775
Add -Depreciation	$111,375	$151,875	$50,625
Net Cash Flows	$66,150	$82,350	$41,850
Release of Net working capital			$9,000
Net cash flow from sale of equipment (As per Note 2)			$26,325
Total Cash flow	$66,150	$82,350	$77,175

Notes-

1. Calculation of depreciation on equipment-

Year 1- ($270,000+$67,500)* 33% = $111,375

Year 2- ($270,000+$67,500)* 45% = $151,875

Year 3 - ($270,000+$67,500)* 15% = $50,625

2. Net cash flow from sale of equipment-

Carrying value of the equipment at the end of year 3 = $337,500- $111,375-$151,875-$50,625 = $23,625

Sales Price= $67,500

Net gain = $67,500-$23,625 = $43,875

Tax on net gain = $43,875*40% = $17,550

Net cash flow = $26,325