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?

   _____Yes or No?
   B16 A B D E 1 $120,000 $30,000 $36,000 $13,000 $52,000 12.00% 40.00% 2 3 Base price 4 Additional modification costs 5 Before-tax salvage proceeds 6 Change in NOWC 7 Before-tax labor cost savings 8 WACC 9 Tax rate 10 11 12 Depreciation rates 13 14 15 16 Base price 17 Modification costs 18 NOWC Yr. O Yr. 1 Yr. 2 Yr. 3 0.33 0.45 0.15 Yr. O Yr. 1 Yr. 2 Yr. 3
   

Answer 1

Solution:

a)Calculation of  initial investment outlay for the spectrometer:

Initial Investment=Price of equipment+Modification cost+Net working capital requirement

=$120,000+$30,000+$13,000

=$163,000

b)Calculation of project's annual cash flows in Years 1, 2, and 3

Annual depreciation on equipment:

Year1=Depreciable amount*rate

=($120,000+$30,000)*33%=$49,500

Year 2=$150,000*45%=$67,500

Year 3=$150,000*15%=$22,500

Year 4=$150,000*7%=$10,500

Tax on sale of equipment=(Sale price-Book value)(tax rate)

=($36,000-$10,500)(0.40)=$10200

After tax sale proceed=$36000-$10,200=$25,800

Thus calculation of annual cash flows are as follow;

Year	1	2	3
Cost saved	$52,000	$52,000	$52,000
Less:Depreciation	$49,500	$67,500	$22,500
Net Cost saved	$2500	-$15500	$29,500
Less:Tax @40%	$1000	$0	$11800
Cost saved after tax	$1500	-$15,500	$17,700
Add:depreciation	$49,500	$67,500	$22,500
Add:After tax sale proceed			$25,800
Add:Working capital recapture			$13000
Cash flows	$51,000	$52,000	$79,000

c)Calculation of Net Present value(NPV)

NPV=Present value of annual cash flows-Initial Investment

Present value of annual cash flows is;

=$51,000/(1.12)^1+$52,000/(1.12)^2+$79,000/(1.12)^3

=$143,220

NPV=$143,220-$163,000

=-$19,780

Since the NPV of the project is negative,hence the project should not be accepted.