Question

12-8. NEW PROJECT ANALYSIS You must evaluate the purchase of a proposed spectrometer for the R&D department. The purchase price of the spectrometer including modifications is $170,000, and the equipment will be fully depreciated at the time of purchase. The equipment would be sold after 3 years for $60,000. The equipment would require an $8,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $50,000 per year in before-tax labor costs. The firm's marginal federal-plus - state tax rate is 25%. a. What is the initial investment outlay for the spectrometer after bonus depreciation is considered, that is, what is the Year O project cash flow? Answer b. What are the project's annual cash flows in Years 1, 2, and 3? Answer c. If the WACC is 10%, should the spectrometer be purchased? Explain. Answer

Answer 1

a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital - Tax savings from depreciation
=-170000-8000+170,000*25%
-135500	since outflow
b.Annual Cash Flows:
	Year 1	2	3
Savings in Cost	50,000	50,000	50,000
Less: Depreciation	0	0	0
Net Savings	50,000	50,000	50,000
Less: Tax @25%	12,500.00	12,500.00	12,500.00
Income after Tax	37,500.00	37,500.00	37,500.00
Add: Depreciation	0	0	0
Cash Flow	37,500.00	37,500.00	37,500.00
Add: After tax salvage value			45,000.00
Recovery of Working capital			8,000
Cash Flow	37,500.00	37,500.00	90,500.00
c.NPV = Present value of cash inflows – present value of cash outflows
= 37500*PVF(10%, 1 year) + 37500*PVF(10%, 2 years) + 90500*PVF(10%, 3 years) – 135500
-2423.37
No, should not be purchased (since NPV is negative)