Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $260,000, and it would cost another $52,000 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 $130,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $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 $40,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%. 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. $ 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 $ If the WACC is 11%, should the spectrometer be purchased? -Select-Yes,No

• Check My Work (1 remaining)

Answer 1

a.

Initial Investment = Cost of asset + Working Capital

= 260000+52000+12000 = 324000

b.

Year	CF	Tax Saving on Dep.	WC	Net profit after tax	Total
0	-312000		-12000		-324000
1	24000	41184			65184
2	24000	56160			80160
3	24000	18720	12000	54080	108800
					-69856

CF in year 1-3 are after-tax Cash flows = 40000*(1-40%) = 24000

Working capital will be added in year 0 and released in year 3, therefore it is an outflow in year 0 and an inflow in year 3

Depreciation will be calculated with the MARR rates.

Tax saving on depreciation will be considered

Tax saving on depreciation in Year1 = 312000*33%*40% = 41184

Book Value in Year 3 of the asset = Cost - depreciation up to the third year

= 312000 - 312000(33%+45%+15%) = 21840

Selling price at year 3 = 130000

Profit = 130000 - 21840 = 108160

Net profit after tax = 108160*(1-40%) = 54080

c.

Spectrometer should not be purchased due to negative total cash flow. There is no point in discounting cash flows with wacc@11% because discounting will increase the negative cash flow even further.