Question

NEW PROJECT ANALYSIS

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $200,000, and it would cost another $30,000 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 $70,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $11,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $58,000 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?
   -Select-YesNo

Answer 1

Initial Investment = Base Price + Modification Cost
Initial Investment = $200,000 + $30,000
Initial Investment = $230,000

Useful Life = 3 years

Depreciation Year 1 = 33% * $230,000
Depreciation Year 1 = $75,900

Depreciation Year 2 = 45% * $230,000
Depreciation Year 2 = $103,500

Depreciation Year 3 = 15% * $230,000
Depreciation Year 3 = $34,500

Book Value at the end of Year 3 = $230,000 - $75,900 - $103,500 - $34,500
Book Value at the end of Year 3 = $16,100

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $70,000 - ($70,000 - $16,100) * 0.40
After-tax Salvage Value = $48,440

Initial Investment in NWC = $11,000

Answer a.

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$230,000 - $11,000
Net Cash Flows = -$241,000

Answer b.

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $58,000 * (1 - 0.40) + 0.40 * $75,900
Operating Cash Flow = $65,160

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $65,160

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $58,000 * (1 - 0.40) + 0.40 * $103,500
Operating Cash Flow = $76,200

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $76,200

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $58,000 * (1 - 0.40) + 0.40 * $34,500
Operating Cash Flow = $48,600

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $48,600 + $11,000 + $48,440
Net Cash Flows = $108,040

Answer c.

WACC = 12%

NPV = -$241,000 + $65,160/1.12 + $76,200/1.12^2 + $108,040/1.12^3
NPV = -$45,174.52

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