Question

NEW PROJECT ANALYSIS

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $160,000, and it would cost another $40,000 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 $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 $41,000 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 13%, should the spectrometer be purchased?
   -Select-YesNo

Answer 1

Initial Investment = Base Price + Modification Cost
Initial Investment = $160,000 + $40,000
Initial Investment = $200,000

Useful Life = 3 years

Depreciation Year 1 = 33% * $200,000
Depreciation Year 1 = $66,000

Depreciation Year 2 = 45% * $200,000
Depreciation Year 2 = $90,000

Depreciation Year 3 = 15% * $200,000
Depreciation Year 3 = $30,000

Book Value at the end of Year 3 = $200,000 - $66,000 - $90,000 - $30,000
Book Value at the end of Year 3 = $14,000

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $72,000 - ($72,000 - $14,000) * 0.40
After-tax Salvage Value = $48,800

Initial Investment in NWC = $7,000

Answer a.

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$200,000 - $7,000
Net Cash Flows = -$207,000

Answer b.

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $41,000 * (1 - 0.40) + 0.40 * $66,000
Operating Cash Flow = $51,000

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $51,000

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $41,000 * (1 - 0.40) + 0.40 * $90,000
Operating Cash Flow = $60,600

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $60,600

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $41,000 * (1 - 0.40) + 0.40 * $30,000
Operating Cash Flow = $36,600

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $36,600 + $7,000 + $48,800
Net Cash Flows = $92,400

Answer c.

Required Return = 13%

NPV = -$207,000 + $51,000/1.13 + $60,600/1.13^2 + $92,400/1.13^3
NPV = -$50,370.73

NPV of the spectrometer is negative. So, you should not purchase the spectrometer.