Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $80,000, and it would cost another $16,000 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 $40,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $12,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $79,000 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 14%, should the spectrometer be purchased?

   _____YesNo

Answer 1

Total cost of spectrometer = purchase cost + modification cost

Operating cash flow (OCF) each year = income after tax + depreciation

profit on sale of spectrometer at end of year 3 = sale price - book value

book value = original cost - accumulated depreciation

after-tax salvage value = salvage value - tax on profit on sale of spectrometer

a] and b]

The Project cash flows are shown below :

c]

NPV is calculated using NPV function in Excel

NPV is $56,458.68

Yes, the spectrometer should be purchased as the NPV is positive

DE 2 Initial Investment 3 Total cost of spectrometer 4 Investment in working capital S $ 96,000.00 12,000.00 8 6 OCF 7 Pretax cost savings - Depreciation 9 EBIT 10 - Taxes 11 Income after tax 12 + Depreciation 13 OCF $ 79,000.00 $31,680.00 $ 47,320.00 $ 18,928.00 $ 28,392.00 $31,680.00 $ 60,072.00 $ 79,000.00 $43,200.00 $ 35,800.00 $ 14,320.00 $ 21,480.00 $ 43,200.00 $ 64,680.00 $ 79,000.00 $14,400.00 $ 64,600.00 $ 25,840.00 $ 38,760.00 $ 14,400.00 $ 53,160.00 14 15 Terminal Cash Flow 16 Salvage Value 17 Accumulated depreciation 18 Book value 19 Profit on sale of spectrometer 20 Tax 21 Salvage Value after tax 22 Recovery of working capital 23 Terminal Cash Flow 24 25 NPV Analysis 26 Project Cash Flows $ 40,000.00 $ 89,280.00 $ 6,720.00 $ 33,280.00 $ 13,312.00 $ 26,688.00 $ 12,000.00 $ 38,688.00 $(108,000.00) $ 60,072.00 $ 64,680.00 $91,848.00 27 28 NPV $ 56,458.68