Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $170,000, and it would cost another $25,500 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 $76,500. 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 $42,000 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 10%, should the spectrometer be purchased?

Answer 1

a.
Calculation of initial investment outlay for spectrometer at year 0
Purchase of spectrometer	-$170,000
Cost to modify	-$25,500
Net working capital	-$9,000
Initial investment outlay	-$204,500
b.
Calculation of project's annual cash flows in each of the three years is shown below
Year	1	2	3
Savings in labor costs	$42,000	$42,000	$42,000
Depreciation expense	$64,515	$87,975	$29,325
	(195500*33%)	(195500*45%)	(195500*15%)
Savings before tax	-$22,515	-$45,975	$12,675
Tax @ 40%	$9,006	$18,390	-$5,070
Savings after tax	-$13,509	-$27,585	$7,605
Add: Depreciation	$64,515	$87,975	$29,325
Net operating cash flow	$51,006.00	$60,390.00	$36,930.00
c.
Calculation of net present value of investment
Year	0	1	2	3
Initial investment outlay	-$204,500.00
Net operating cash flow		$51,006.00	$60,390.00	$36,930.00
Recovery of working capital				$9,000.00
After tax salvage revenue				$51,374.00
Net cash flow	-$204,500.00	$51,006.00	$60,390.00	$97,304.00
Discount factor @ 10%	1.000000	0.909091	0.826446	0.751315
Present value	-$204,500	$46,369	$49,909	$73,106
Net present value	-$35,115.88
Since the net present value is negative, company should not purchase spectrometer.
Calculation of after tax salvage revenue
Sales proceed from asset	$76,500
Less: Book value	$13,685	(195500*7%)
Gain from sale of asset	$62,815
Tax on gain	$25,126	62815*40%
After tax salvage revenue	$51,374	(76500-25126)