Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $80,000, and it would cost another $12,000 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 $40,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $7,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $36,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.

1. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent. Negative amount should be indicated by a minus sign.
   $

2. What are the project's annual cash flows in Years 1, 2, and 3? Round your answers to the nearest cent.

   In Year 1 $

   In Year 2 $

   In Year 3 $

3. If the WACC is 10%, should the spectrometer be purchased?

Answer 1

Time line		0	1	2	3
Cost of new machine		-92000
Initial working capital		-7000
=Initial Investment outlay (a.)		-99000
						100.00%	0.0000%
Profits			36000	36000	36000
-Depreciation	Cost of equipment/no. of years		-30360	-41400	-13800	6440	=Salvage Value
=Pretax cash flows			5640	-5400	22200
-taxes	=(Pretax cash flows)*(1-tax)		3384	-3240	13320
+Depreciation			30360	41400	13800
=after tax operating cash flow			33744	38160	27120
reversal of working capital					7000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				24000
+Tax shield on salvage book value	=Salvage value * tax rate				2576
=Terminal year after tax cash flows					33576
Total Cash flow for the period (b.)		-99000	33744	38160	60696
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331
Discounted CF=	Cashflow/discount factor	-99000	30676.364	31537.1901	45601.803
NPV=	Sum of discounted CF=	8815.35687

c. NPV is greater than 0 hence buy the equipment