Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $290,000, and it would cost another $43,500 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 $116,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $15,000 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%.

• 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.
  $

• 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 $

• If the WACC is 10%, should the spectrometer be purchased?

Answer 1

initial investment outlay = base price+modification expenses + increase in working capital

= 290000+43500+15000

= -348,500(since it is out flow it should represent negative sign)

value of spectrometer = 290000+43500 = 3335000

Depreciation Year 1 = $333,500 * 33% = 110,055

Year 2 = $333,500 * 45% = 150,075

Year 3 = $333,5000 * 15% = 50,025

Book value after 3 years = 333500 - (110055+150075+50025)

= 23345

sale value after 3 years = 116000

tax on gain = (116000 - 23345) * 40% = 37062

after tax sale value = 116000 - 37062 = 78938

Project's annual cash flows = cost savings(1 - tax) + depreciation*tax

Year 1 = 78000(1-0.4) + 110055*40% = 90822

Year 2 = 78000(1-0.4) + 150075 *40% = 106830

Year 3 cash flow = cost savings(1 - tax) + depreciation*tax +sale value after tax + recovery of working capital

= 78000(1-0.4) +50025*40% + 78938 +15000 = 160748

NPV =-initial investment + present value of future cash flows (given WACC = 10%)

= -348500 + 90822/(1.1)^1 + 106830 / (1.1)^2 + 160748 / (1.1)^3

= -348500+291627.06

NPV = -56,872.94

Since NPV is negative spectrometer should not be purchased