Question

New project analysis

You must evaluate a proposed spectrometer for the R&D department. The base price is $270,000, and it would cost another $54,000 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 $108,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $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 $75,000 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.
   $   
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?
   -Select-yesnoItem 5

Answer 1

Initial Investment = Base Price + Modification Cost
Initial Investment = $270,000 + $54,000
Initial Investment = $324,000

Useful Life = 3 years

Depreciation Year 1 = 33% * $324,000
Depreciation Year 1 = $106,920

Depreciation Year 2 = 45% * $324,000
Depreciation Year 2 = $145,800

Depreciation Year 3 = 15% * $324,000
Depreciation Year 3 = $48,600

Book Value at the end of Year 3 = $324,000 - $106,920 - $145,800 - $48,600
Book Value at the end of Year 3 = $22,680

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $108,000 - ($108,000 - $22,680) * 0.40
After-tax Salvage Value = $73,872

Initial Investment in NWC = $12,000

Answer a.

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$324,000 - $12,000
Net Cash Flows = -$336,000

Answer b.

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $75,000 * (1 - 0.40) + 0.40 * $106,920
Operating Cash Flow = $87,768

Net Cash Flow = Operating Cash Flow
Net Cash Flow = $87,768

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $75,000 * (1 - 0.40) + 0.40 * $145,800
Operating Cash Flow = $103,320

Net Cash Flow = Operating Cash Flow
Net Cash Flow = $103,320

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $75,000 * (1 - 0.40) + 0.40 * $48,600
Operating Cash Flow = $64,440

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $64,440 + $12,000 + $73,872
Net Cash Flows = $150,312

Answer c.

WACC = 10%

NPV = -$336,000 + $87,768/1.10 + $103,320/1.10^2 + $150,312/1.10^3
NPV = -$57,890.85

NPV of the investment is negative. So, you should not purchase the spectrometer.