Question

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 $108,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $8,000 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%.

a-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.
$

b-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 $

c-If the WACC is 13%, should the spectrometer be purchased?

Answer 1

A- Initial investment outlay = base price+ modification cost + investment in working capital= 240000+36000+8000= $284000

B- Calculation of Annual Cashflows

	PARTICULARS	YEAR 1	YEAR 2	YEAR 3
	Saving in Labor costs	66000	66000	66000
Less:	Depreciation	91080	124200	41400
	Profit before tax	-25080	-58200	24600
Less:	tax@40%	0	0	9840
	Net Income	-25080	-58200	14760
Add:	Depreciation	91080	124200	41400
Add:	After tax salvage value(WN)	0	0	72528
	Annual Cash flow	66000	66000	128688

Working Note:

1) After Tax salvage value= Sale price- (tax on profit on sale of equipment)= $108000 - ( $88680 * 0.40 )= $72528

profit on sale of equipment= sale - bookvalue= 276000- (276000-91080-124200-41400) = $88680

2) Depreciation is calculated on capitalised cost i.e. $240000 + $36000 = $276000

C) Calculation of NPV of investment

Annual Cash flow	66000	66000	128688
PVAF@13%	0.884956	0.783147	0.69305
PV	58407.08	51687.68	89187.24

Therefore NPV = Total Present Value of annual cash inflows - Initial Outlay = $199282- $284000= -$84718

Since NPV is negative so  spectrometer should not be purchased.