Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $120,000, and it would cost another $18,000 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 $36,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $10,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $68,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 35%. a) 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. b) 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. c) If the WACC is 10%, should the spectrometer be purchased?

Answer 1

Tax rate		35%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3			Total
Cost		$           138,000	$          138,000	$           138,000
Dep Rate (1/3=33.33%)		33.00%	45.00%	15.00%
Depreciation	Cost * Dep rate	$             45,540	$             62,100	$             20,700			$           128,340
Calculation of after-tax salvage value
Cost of machine			$          138,000
Depreciation			$          128,340
WDV	Cost less accumulated depreciation	$               9,660
Sale price			$             36,000
Profit/(Loss)	Sale price less WDV		$             26,340
Tax	Profit/(Loss)*tax rate	$               9,219
Sale price after-tax	Sale price less tax		$             26,781
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3
Labor cost saving		$             68,000	$            68,000	$             68,000
Less: Depreciation		$             45,540	$             62,100	$             20,700
Profit before tax (PBT)		$             22,460	$               5,900	$             47,300
Tax@35%	PBT*Tax rate	$                7,861	$               2,065	$             16,555
Profit After Tax (PAT)	PBT - Tax	$             14,599	$               3,835	$             30,745
Add Depreciation	PAT + Dep	$             45,540	$             62,100	$             20,700
Cash Profit after-tax		$             60,139	$            65,935	$             51,445
Calculation of NPV
						10.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor, 1/(1+r)^time	Present values
0		$          (138,000)	$           (10,000)		$               (148,000)	1.0000	$    (148,000.00)
1				$             60,139	$                   60,139	0.9091	$        54,671.82
2				$             65,935	$                   65,935	0.8264	$        54,491.74
3		$             26,781	$             10,000	$             51,445	$                   88,226	0.7513	$        66,285.50
					Net Present Value		$       27,449.05
Since, NPV is positive, the Spectrometer should be purchased.