Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $70,000, and it would cost another $17,500 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 $17,500. 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 $78,000 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 12%, should the spectrometer be purchased?

Answer 1

	a	Initial Investment Outlay
		Base Price	($70,000)
		Modify equipment	($17,500)
		Increase in net operating capital	($7,000)
		Initial Investment Outlay	($94,500)
	b	Annual Cash Flow:
		Total investment in equipment	$87,500	(70000+17500)
		Depreciation tax shield:
	n	Year	1	2	3
	A	Depreciation Rate	33%	45%	15%
	B=87500*A	Annual Depreciation	$28,875	$39,375	$13,125
	C	Accumulated Depreciation	$28,875	$68,250	$81,375
	D=87500-C	Book Value	$58,625	$19,250	$6,125
	E=B*40%	Depreciation tax shield:	$11,550	$15,750	$5,250
	F	Before tax saving in labor cost	$78,000	$78,000	$78,000
	G=F*(1-0.4)	After tax savings in labor cost	$46,800	$46,800	$46,800
	H	Depreciation tax shield:	$11,550	$15,750	$5,250
	I	Before tax salvage value			$17,500
	J	Book Value at end of 3 years			$6,125
	K=I-J	Gain on Salvage			$11,375
	L=K*40%	Tax on gain			$4,550
	M=I-L	After tax Salvage Value			$12,950
	N	Release of net working capital			$7,000
	P=G+H+M+N	Annual Cash Flow:	$58,350.00	$62,550.00	$72,000.00	SUM
	PV=P/(1.12^n)	Present Value of Cash In Flow	$52,098.21	$49,864.48	$51,248.18	$153,210.87
		Annual Cash Flow in Year1	$58,350.00
		Annual Cash Flow in Year2	$62,550.00
		Annual Cash Flow in Year3	$72,000.00
	c	WACC=12%
		Present Value of Cash Flow=(Annual cash Flow)/(1.12^n)
		n=Year of cash flow
		Net Present value =(Sum of Present Value of Cash Inflows)-(Initial Investment Outlay)
		Net Present value =153210.87-94500=	$58,710.87
		The Spectrometer should be purchased
		Net Present Value is Positive