Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $150,000, and it would cost another $22,500 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 $37,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $13,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $49,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.

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.
$

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 $

If the WACC is 11%, should the spectrometer be purchased?

Answer 1

Cost of machine = $150,000 + $22,500 = $172,500

Initial investment outlay = Cost of spectrometer + Working capital required = $172,500 + $13,000 = (-)$185,500

Depreciation schedule

Year	Depreciation	Depreciation tax shield
1	$172,500 x 33% = $56,925	$56,925 x 40% = $22,770
2	$172,500 x 45% = $77,625	$77,625 x 40% = $31,050
3	$172,500 x 15% = $25,875	$25,875 x 40% = $10,350

Book value of spectrometer at the end of year 3 = $172,500 - [$56,925 + $77,625 + $25,875] = $12,075

Tax on gain on sale = ($37,500 - $12,075) x 40% = $10,170

Salvage value net of tax = $37,500 - $10,170 = $27,330

Annual cash flows

Particulars	Year 1	Year 2	Year 3
Savings in labor costs net of tax [$49000 x (1 - 0.40)]	$29,400	$29,400	$29,400
Add: Depreciation tax savings	$22,770	$31,050	$10,350
Add: Salvage value net of tax			$27,330
Add: working capital recovered			$13,000
Annual Cash Flows	$52,170	$60,450	$80,080

NPV = (-)185,500 + [ $52,170 / (1 + 0.11)¹ ] + [ $60,450 / (1 + 0.11)² ] + [ $80,080 / (1 + 0.11)³ ] = (-)30,883.618097 or (-)30,883.62

Since NPV is negative, spectrometer should not be purchased.

Note : In Year 3, I assumed that working capital is recovered since nothing is mentioned regarding this. In case you get an incorrect answer, try removing working capital in year 3.