Question

You must evaluate the purchase of a spectrometer for the R&D department. The base price is $140,000, and it would cost another $30,000 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 $60,000. The applicable depreciation rates are 33%, 45%, 15%, and 7% as discussed in Appendix 12A. The equipment would require an $8,000 increase in net operating working working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $50,000 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 project? That is, what is the Year 0 project cash flow?

B) What is the projects incremental depreciation (depreciation expense) for year 1?

C) What is the projects annual cash flow for year 1?

D) What is the projects annual cash flow for year 2?

E) What is the projects incemental depreciation (depreciation expense) for year 3?

F) What is the projects cash flow for year 3? (Do not include the terminal cash flows.)

G) Sale of Equipment: What is the projects cash flow from the sale of equipment in year 3?

H) Liquidation of Net Operating Working Capital: What is the projects cash flow from the liquidation of net operating working capital (spare parts inventory) in year 3?

I) What is the projects terminal cash flow for year 3? (Not the operating cash flow)

J) What is the project's Net Present Value (NPV)?

K) What is the projects Internal Rate of Return (IRR)?

L) What is the projects Modified Internal Rate of Return (MIRR)?

Answer 1

Tax rate	40%
	Year-1	Year-2	Year-3
Saving in costs	50,000	50,000	50,000
Less: Depreciation as per table given below	56,100	76,500	25,500
Profit before tax	(6,100)	(26,500)	24,500
Tax	(2,440)	(10,600)	9,800
Profit After Tax	(3,660)	(15,900)	14,700
Add Depreciation	56,100	76,500	25,500
Cash Profit After tax	52,440	60,600	40,200
Cost of macine		170,000
Depreciation		158,100
WDV		11,900
Sale price		60,000
Profit/(Loss)		48,100
Tax		19,240
Sale price after tax		40,760
Depreciation	Year-1	Year-2	Year-3			Total
Cost	170,000	170,000	170,000
Dep Rate	33.00%	45.00%	15.00%
Deprecaition	56,100	76,500	25,500			158,100
Calculation of NPV
Year	Captial	Working captial	Operating cash	Annual Cash flow	PV factor @ 10%- Rate is assumed	Present values
0	(170,000)	(8,000)		(178,000)	1.000	(178,000)
1			52,440	52,440	0.909	47,673
2			60,600	60,600	0.826	50,083
3	40,760	8,000	40,200	88,960	0.751	66,837
				Net Present Value		(13,408)
Calculation of IRR
Year	Annual Cash flow	PV factor @ 5%	Present values	PV factor @ 10%	Present values
0	(178,000)	1.000	(178,000)	1.000	(178,000)
1	52,440	0.952	49,943	0.909	47,673
2	60,600	0.907	54,966	0.826	50,083
3	88,960	0.864	76,847	0.751	66,837
			3,756		(13,408)
	IRR	=Lower rate + Difference in rates*(NPV at lower rate)/(Lower rate NPV-Higher rate NPV)
	IRR	=5%+5%*(3756/(3756+13408))
		6.09%
Calculation of MIRR
Year	Annual Cash flow	Future Value factor @ 5%	Present values
1	52,440	1.103	57,815
2	60,600	1.050	63,630
3	88,960	1.000	88,960
			210,405
	MIRR	=[(FV of Outflow/Initial Outflow)^(1/n)]-1
	MIRR	=[(210405/178000)^(1/3)]-1
	MIRR	5.733%