Question

1. 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 $70,000, and it would cost another $15,000 to modify it for special use by your firm. The chromatograph, which falls into the MACRS 3-year class, would be sold after 3 years for $30,000. The MACRS rates for the first three years are 0.3333, 0.4445, and 0.1481. 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 $25,000 per year in before-tax operating costs, mainly labor. The firm’s marginal federal-plus-state tax rate is 40%.
   1. What is the Year-0 net cash flow?
   2. What are the net operating cash flows in Years 1, 2, and 3?
   3. What is the additional (nonoperating) cash flow in Year 3?
   4. If the project’s cost of capital is 10%, should the chromatograph be purchased?

Answer 1

a) Year 0 net cash flow is -$89,000

b) Net Operating cash flow for year 1 is $26,332.20

  Net Operating cash flow for year 2 is $30,113.00

  Net Operating cash flow for year 3 is $20,035.40

c) Terminal Value in year 3 is $26,519.40   

d) NPV of the Chromatograph is -$5,197.55

NPV is negative hence Chromatograph should not be purchased

Calculation of Project's NPV
Particulars	Year 0	Year 1	Year 2	Year 3
Initial Investment
Chromatographer Price	-70000
Modification cost	-15000
Cost basis (A)	-85000
Working Capital required (B)	-4000
Net Investment (C = A+B)	-89000
Operating Cashflows
Saving in Pre tax Costs (D)		25000	25000	25000
Less: Depreciation(E) ($85,000 * 33.33%, 44.45%,14.81%)		28330.5	37782.5	12588.5
Profit Before tax (F = C-D-E)		-3330.5	-12782.5	12411.5
Less: Tax@40% (G = F*40%)		-1332.2	-5113	4964.6
Profit After Tax (H = F-G)		-1998.3	-7669.5	7446.9
Add back Depreciation ( I= E)		28330.5	37782.5	12588.5
Net Operating Cashflows (J = H+I)		26332.2	30113	20035.4
Terminal Value
Salve value (K)				30000
Less: Unclaimed Depreciation (L)            ($85,000 *7.41%)				6298.5
profit before tax (M = K-L)				23701.5
Less: Tax@40% (N= M*40%)				9480.6
Profit After Tax (O = M-N)				14220.9
Add back Depreciation (P = L)				6298.5
Net Salvage value (Q = O+P)				22519.4
Working capital realized (R )				4000
Net Terminal Value (S = Q+R)				26519.4
Total Cashflows (T = C+J+S)	-89000	26332.2	30113	46554.8
Discount Rate @10% (U) (1+10%)^n n=0,1,2,3	1	0.90909091	0.826446	0.751315
Discounted Cashflows (V = T*U)	-89000	23938.3636	24886.78	34977.31
Net Present Value	-5197.55