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 $35,000. 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 $65,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 35%.

1. 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.
   $   
2. 
   
3. 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: $   
4. 
   
5. If the WACC is 14%, should the spectrometer be purchased?

d. Your firm, Agrico Products, is considering a tractor that would have a cost of $37,000, would increase pretax operating cash flows before taking account of depreciation by $13,000 per year, and would be depreciated on a straight-line basis to zero over 5 years at the rate of $7,400 per year, beginning the first year. (Thus, annual cash flows would be $13,000 before taxes plus the tax savings that result from $7,400 of depreciation.) The managers are having a heated debate about whether the tractor would actually last 5 years. The controller insists that she knows of tractors that have lasted only 4 years. The treasurer agrees with the controller, but he argues that most tractors actually do give 5 years of service. The service manager then states that some last for as long as 8 years.

Assume that if the tractor only lasts 4 years, then the firm would receive a tax credit in Year 4 because the tractor's salvage value at that time is less than its book value. Under this scenario, the firm would not take depreciation expense in Year 5.

Given this discussion, the CFO asks you to prepare a scenario analysis to determine the importance of the tractor's life on the NPV. Use a 40% marginal federal-plus-state tax rate, a zero salvage value, and a 11% WACC. Assuming each of the indicated lives has the same probability of occurring (probability = 1/3), what is the tractor's expected NPV?

Do not round intermediate calculations. Negative values, if any, should be indicated by a minus sign. Round your answers to the nearest cent.

1. Tractor's NPV if actual life is 5 years.
   $  
2. 
   
3. Tractor's NPV if actual life is 4 years.
   $  
4. 
   
5. Tractor's NPV if actual life is 8 years.
   $  
6. 
   
7. Tractor's expected NPV.
   $  

Answer 1

a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital
=70,000+14000+9000
93,000	since outflow
b.Annual Cash Flows:
	Year 1	2	3
Savings in Cost	65,000	65,000	65,000
Less: Depreciation	27,720	37,800	12,600
Net Savings	37,280	27,200	52,400
Less: Tax @35%	13,048.00	9,520.00	18,340.00
Income after Tax	24,232.00	17,680.00	34,060.00
Add: Depreciation	27,720	37,800	12,600
Operating Cash Flow	51,952.00	55,480.00	46,660.00
Add: After tax salvage value			24,808.00
Recovery of Working capital			9,000
Additional cash flows			33,808
Annual Cash flows	51,952.00	55,480.00	80,468.00
Written down value	5,880
Sale price	35000
Gain on sale	29,120
Tax	10192
After tax salvage value	24808
c.NPV = Present value of cash inflows – present value of cash outflows
= 51952*PVF(14%, 1 year) + 55480*PVF(14%, 2 years) + 80468*PVF(14%, 3 years) – 93000
49575.59627
Yes, should be purchased (since NPV is positive)