Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $90,000, 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 $40,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $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 $60,000 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. 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.
3. If the WACC is 13%, should the spectrometer be purchased?

Answer 1

Cost of Machine = Base Price + Modification Cost
Cost of Machine = $90,000 + $18,000
Cost of Machine = $108,000

Useful Life = 3 years

Depreciation Year 1 = 33% * $108,000
Depreciation Year 1 = $35,640

Depreciation Year 2 = 45% * $108,000
Depreciation Year 2 = $48,600

Depreciation Year 3 = 15% * $108,000
Depreciation Year 3 = $16,200

Book Value at the end of Year 3 = $108,000 - $35,640 - $48,600 - $16,200
Book Value at the end of Year 3 = $7,560

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $40,500 - ($40,500 - $7,560) * 0.35
After-tax Salvage Value = $28,971

Initial Investment in NWC = $7,000

Answer a.

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$108,000 - $7,000
Net Cash Flows = -$115,000

Answer b.

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $60,000 * (1 - 0.35) + 0.35 * $35,640
Operating Cash Flow = $51,474

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $51,474

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $60,000 * (1 - 0.35) + 0.35 * $48,600
Operating Cash Flow = $56,010

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $56,010

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $60,000 * (1 - 0.35) + 0.35 * $16,200
Operating Cash Flow = $44,670

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $44,670 + $7,000 + $28,971
Net Cash Flows = $80,641

Answer c.

Required Return = 13%

NPV = -$115,000 + $51,474/1.13 + $56,010/1.13^2 + $80,641/1.13^3
NPV = $30,304.52

NPV of the spectrometer is positive. So, you should purchase the spectrometer.