Question

The president of the company you work for has asked you to evaluate the proposed acquisition of a new chromatograph for the firm’s R&D department. The equipment’s basic price is $85,000, and it would cost another $12,000 to install it for special use by your firm. The chromatograph falls into the MACRS 3-year class, and the MACRS rates are 0.3333, 0.4445, 0.1481, and 0.0741. The firm would keep the machine for its entire useful life (that is 4 years), and the machine would be sold after 4 years for $30,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,000. The machine would have no effect on revenues, but it is expected to save the firm $36,000 per year in before-tax operating costs, mainly labor. The firm’s marginal federal-plus-state tax rate is 21%.

1. What is the total initial cash outflow, i.e. CF0?

2. What is the depreciation for each year of the project?

3. Find the incremental operating cash flows for each year 1, year 2, year 3 and year 4.

   OCF1-4=

4. What is the terminal cash flow from after-tax salvage value and working capital recovery? Hint: Since the firm plans to keep the machine for its entire useful life, the book value of the machine will be zero at the end of 4 years

5. What is the net present value of the project? What is the decision on the project?

Answer 1

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Total Initial cash flow

Total Initial Cash Flow = Equipment Base price + Installation cost + Investment in working capital

= $85,000 + $12,000+ $4,000 = $101,000

Total Initial Cash Flow in Year 0 = $101,000

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Depreciation for each year of the project

Depreciation base =   Equipment Base price + Installation cost = $85,000 + $12,000 = $97,000

Depreciation in Year 1 = Depreciation base * 0.3333 = $97,000 * 0.3333 = $32,330.10

Depreciation in Year 2 = Depreciation base * 0.4445 = $97,000 * 0.4445 = $43,116.50

Depreciation in Year 3 = Depreciation base * 0.1481 = $97,000 * 0.1481 = $14,365.70

Depreciation in Year 4 = Depreciation base * 0.0741 = $97,000 * 0.0741 = $7,187.70

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Calculation of incremental operating cash flows

Incremental Operating Cash Flow for Year 1 = $35,229.32

Incremental Operating Cash Flow for Year 2 = $37,494.47

Incremental Operating Cash Flow for Year 3 = $31,456.80

Incremental Operating Cash Flow for Year 4 = $29,949.42

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Calculation of Terminal Cash Flow

After Tax Salvage Value of Equipment = $30,000 * (1-21%) = $23,700

Recovery of Working Capital = $4,000

Terminal Cash Flow = After Tax Salvage Value of Equipment + Recovery of Working Capital = $23,700 + $4,000 = $27,700

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Calculation of Net Present value of the project

Net Present value of the project is $25,023.10

Note:

Discount rate or required rate of return is not given in the problem. Hence discount rate of 10% is considered

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Project is acceptable at the discount rate of 10%