Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $70,000, and it would cost another $14,000 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 $24,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $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 $72,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 35%. 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 cent. $   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 cent. Year 1: $   Year 2: $   Year 3: $   If the WACC is 13%, should the spectrometer be purchased? -Select-YesNoItem 5

Answer 1

a) The initial investment outlay for the spectrometer, Year 0 project cash flow will be:-

Initial Cost of Spectrometer = $70,000 + $14,000 = $84,000

Cash Outflow of year 0 = Initial Cost of Spectrometer + Increase in Net Working Capital = $84,000 + $9,000 = $93,000

As in the question, it was mentioned to give answer in positive values, so even the outflows are mentioned in the positive values.

c) The project's annual cash flows in Years 1, 2, and 3 are as follows :-

Year 1 = After Tax cost savings + Depreciation tax shield = 72,000*(1-35%) + 84,000*33%*35% = $56,502

Year 2 = After Tax cost savings + Depreciation tax shield = 72,000*(1-35%) + 84,000*45%*35% = $60,030

Book value of the Spectrometer at year 3 = 84,000 * (1-33%-45%-15%) = $5,880

Salvage Value of Spectrometer after 3 years is $24,500

Tax = (24,500 – 5,880)*35% = $6,517

After Tax Salvage Value = Salvage Value – Tax = 24,500 – 6,517 = $17,983

Year 3 = After Tax cost savings + Depreciation tax shield + After Tax salvage value + Additional Working Capital Returned = 72,000*(1-35%) + 84,000*15%*35% + 17,983 + 9,000 = $78,193

Year 1: $ 56,502
Year 2: $ 60,030
Year 3: $ 78,193

e) If the WACC is 13%, then Net Present Value (NPV) will be:-

NPV = -84,000 + 56,502/(1+13%) + 60,030/(1+13%)^2 + 78,193/(1+13%)^3

        = -84,000 + 50,001.77 + 47,012.30 + 54,191.67

        = $67,205.74

Yes, as the NPV is positive with WACC of 13%, the spectrometer should be purchased.