Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $120,000, 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 $36,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $13,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $52,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%. The data has been collected in the Microsoft Excel Online file below. Open the spreadsheet and perform the required analysis to answer the questions below.

Open spreadsheet

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?

   _____YesNo

Base price Additional modification costs Before-tax salvage proceeds Change in NOWC Before-tax labor cost savings WACC Tax rate $120,000 $30,000 $36,000 $13,000 $52,000 12.00% 40.00% Yr. O Yr. 1 Yr. 2 Yr. 3 Depreciation rates 0.33 0.45 0.15 Yr. O Yr. 1 Yr. 2 Yr. 3 Base price Modification costs NOWC Before-tax labor cost savings $52,000.00 $52,000.00 $52,000.00

Answer 1

Solution:

a)Initial investment outlay:

=Cost of machine+Modification cost+Net working capital required

=$120,000+$50,000+$13,000

=$183,000

b)Calculation of project's annual cash flows

Depreciation on machine:

Year 1=(Cost of machine+Modification cost)*rate of depreciation

=($120,000+$50,000)*33%=$56,100

Year 2=$170,000*0.45=$76,500

Year 3=$170,000*0.15=$25,500

After tax sale proceed of machine=Sale price-[(Sale price-Book value)*tax rate]

=$36,000-[($360,000-$11,900)*0.40]

=$26,360

Annual cash flows are as follow

Year	1	2	3
Cost saved	$52,000	$52,000	$52,000
Less: Depreciation	56,100	$76,500	$25,500
Net Cost saved	-$4100	-$24,500	$26,500
Less:Tax @40%	$0	$0	$10600
Cost saved after tax	-$4100	-$24,500	$15900
Add:depreciation	56,100	$76,500	$25,500
Add:after tax salvage value			$26,360
Add:Working capital recovery			$13,000
Annual cash flows	$52,000	$52,000	$80,760

c)Calculation of Net Present value of Project(NPV)

Net Present value=Present value of annual cash flows-Initial investment outlay

Present value of annual cash flows is;

=52,000/(1+0.12)^1+52,000/(1+0.12)^2+$80,760/(1+0.12)^3

=$145,366.03

NPV=$145,366.03-$183,000

=-$37,633.97

Since the NPV of project is neagtive,hence the spectrometer should not be purchased,Thus answer is NO.