Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $100,000, and it would cost another $15,000 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 $50,000. 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 $69,000 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?

Answer 1

Answer :-

(a)

Initial investment outlay = Base price + modification cost + increase in net working capital

= 100,000 + 15,000 + 12,000

= 127,000

(b)

Calculation of year 1 , 2 , 3 cash inflow

	Year 1	Year 2	Year 3
After tax Saving in labour cost [ before tax saving * (1-tax rate) ]	44850	44850	44850
Saving of tax in depreciation [ Depreciation * tax rate ]	13282.5	18112.5	6037.5
After tax salvge value			35317.5
Recovery of working capital at the end			12000

Total project annual cash flow

Year 1- 58132.5 Year 2- 62962.5 Year 3- 98205

Calculation of depreciation :-

Cost of asset = base price + modification cost

= 100,000 + 15,000 ==> 115,000

Year 1 depreciation = 115000 * 33% = 37950

Year 2 depreciation = 115000 * 45% = 51750

Year 3 depreciation = 115000 * 15% = 17250

Calculation of after tax salvage value

Remaining balance after depreciation = 115000 - 37950 - 51750 - 17250

=8050

Gain on sale = 50000 - 8050

= 41950

Tax on gain on sale = 41950 * 35% = 14682.5

After tax salvage value = salvage value - tax on salvage value

= 50000 - 14682.5

= 35317.50

(c)

Calvulation of NPV if WACC is 14%

PV of cash inflow - cash ouflow

	Annual Cash inflow	PV factor @ 14%	PV of cash inflow
Year 1	58132.5	0.877	50982
Year 2	62962.5	0.769	48418
Year 3	98205	0.675	66288
		Total	165688

NPV = 165688 - 127000

=38,688

Yes, it should be purchased as it has positive NPV.