Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The purchase price of the spectrometer including modifications is $250,000, and the equipment will be fully depreciated at the time of purchase. The equipment would be sold after 3 years for $43,000. 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 $23,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 25%.

What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest dollar. $

What are the project's annual cash flows in Years

1,

2

and 3? Do not round intermediate calculations. Round your answers to the nearest dollar.

Year 1:

Year 2:

Year 3:

If the WACC is 14%, should the spectrometer be purchased?

Answer 1

Following information is given in the question:

1. Spectrometer cost is $250,000
2. Salvage value of Spectrometer is $43,000 after 3 years
3. Working capital requirement is $9,000
4. Labor cost saving is $23,000 per year
5. Tax rate is 25%

Statement showing cash flows in Year 1, 2 and 3 with Initial Outlay

Particulars	Year 0	Year 1	Year 2	Year 3
Spectrometer cost	$ (250,000.00)	$                      -	$                      -	$                      -
Working capital	$       (9,000.00)	$                      -	$                      -	$         9,000.00
Labor cost saving	$                      -	$       23,000.00	$       23,000.00	$       23,000.00
Salvage value of Spectrometer	$                      -	$                      -	$                      -	$       43,000.00
Depreciation	$ (250,000.00)	$                      -	$                      -	$                      -
Earning before tax	$ (509,000.00)	$       23,000.00	$       23,000.00	$       75,000.00
Tax @ 25%	$     127,250.00	$       (5,750.00)	$       (5,750.00)	$     (18,750.00)
Earning after tax	$ (381,750.00)	$       17,250.00	$       17,250.00	$       56,250.00
Depreciation	$     250,000.00	$                      -	$                      -	$                      -
Cash Flows	$ (131,750.00)	$       17,250.00	$       17,250.00	$       56,250.00

If the WACC is 14% ,would the spectrometer be purchased or not can be determined using Net Present value of the cash flows calculated above

Statement showing Net Present Value

Period	Particulars	Amount (a)	Discounted Factor @ 14% (b)	Present Value (a * b)
0	Cash Flows	$ (131,750.00)	1	$ (131,750.00)
1	Cash Flows	$      17,250.00	0.8772	$       15,131.70
2	Cash Flows	$      17,250.00	0.7695	$       13,273.88
3	Cash Flows	$      56,250.00	0.6750	$       37,968.75
	Net Present Value			$     (65,375.68)

It is not financially viable to purchase Spectrometer since the NPV is negative.