Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $240,000, and it would cost another $48,000 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 $72,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $9,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $61,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.

a. 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.

b. 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 $ ________

c. If the WACC is 13%, should the spectrometer be purchased?

Answer 1

a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital

= -240,000-48,000-9,000

= -$297,000

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	61,000	61,000	61,000
Less: Depreciation	95,040	129,600	43,200
Net Savings	-34,040	-68,600	17,800
Less: Tax @40%	-13,616	-27,440	7,120
Income after Tax	-20,424	-41,160	10,680
Add: Depreciation	95,040	129,600	43,200
Cash Flow	74,616	88,440	53,880
Add: After tax salvage value			51,264
Recovery of Working capital			9,000
Cash Flow	74,616	88,440	114,144

Note: Written down value of machine = 288,000*7% = $20,160

Sale Price = $72,000

Gain on Sale = $51,840

Tax on Gain = $20,736

After tax salvage value = 72,000 – 20,736 = $51,264

c.NPV = Present value of cash inflows – present value of cash outflows

= 74,616*PVF(13%, 1 year) + 88,440*PVF(13%, 2 years) + 114,144*PVF(13%, 3 years) – 297,000

= 74,616*0.885 + 88,440*0.783 + 114,144*0.693 - 297,000

= -$82,614.53

No, should not be purchased (since NPV is negative)