Question

PLEASE SHOW ALL WORK

You have been asked by the president of your company to evaluate the proposed acquisition of a new spectrometer for the firm’s R&D department. The equipment’s basic price is $70,000 and it would cost another $15,000 to modify it for special use by your firm. The spectrometer, which has a MACRS 3-year recovery period, would be sold after 3 years for $30,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,000. The spectrometer would have no effect on revenues, but it is expected to save the firm $25,000 per year in before-tax operating costs, mainly labor. The firm’s marginal tax rate is 40 percent. If the project’s cost of capital is 10 percent, should the firm purchase the spectrometer? Answer based on (i) the NPV, (ii) the IRR, (iii) the profitability index, and (iv) the payback rule (your firm accepts projects with a payback of 3 years or less).

Answer 1

Year		1	2	3	4	5
Equipment cost	70,000
Modification	15,000
Total	85,000
Cost of capital at 10%		8,500	8,500	8,500	8,500	8,500
Cost of working capital at 10%		400	400	400	400	400
Total A		8,900	8,900	8,900	8,900	8,900
Salvage							30,000
Savings per year B		25,000	25,000	25,000	25,000	25,000
Savings A-B		16,100	16,100	16,100	16,100	16,100
Tax at 40%		6,440	6,440	6,440	6,440	6,440
Profit after tax		9,660	9,660	9,660	9,660	9,660
Cash accrual		9,660	19,320	28,980	38,640	48,300	78,300
IRR		11.36	11.36	11.36	11.36	11.36
PAY BACK PERIOD 5 YEARS AND SO THE PROPOSAL SHOULD NOT BE ACCEPTED