Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $250,000, and it would cost another $62,500 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 $125,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $5,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $56,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below.

Open spreadsheet

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 11%, should the spectrometer be purchased?

   _____YesNo

Answer 1

Time line		0	1	2	3
Cost of new machine		-312500
Initial working capital		-5000
=a. Initial Investment outlay		-317500
3 years MACR rate			33.00%	45.00%	15.00%	7.00%
Savings			56000	56000	56000
-Depreciation	=Cost of machine*MACR%		-103125	-140625	-46875	21875	=Salvage Value
=Pretax cash flows			-47125	-84625	9125
-taxes	=(Pretax cash flows)*(1-tax)		-28275	-50775	5475
+Depreciation			103125	140625	46875
=b. after tax operating cash flow			74850	89850	52350
reversal of working capital					5000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				75000
+Tax shield on salvage book value	=Salvage value * tax rate				8750
=Terminal year after tax cash flows					88750
Total Cash flow for the period		-317500	74850	89850	141100
Discount factor=	(1+discount rate)^corresponding period	1	1.11	1.2321	1.367631
Discounted CF=	Cashflow/discount factor	-317500	67432.43243	72924.27563	103171.1
c. NPV=	Sum of discounted CF=	-73972.19

DO not purchase as NPV is negative