Question

You must evaluate the purchase of a proposed spectrometer for the R&D department. The base price is $300,000, and it would cost another $75,000 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 $90,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $9,000 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%.

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 14%, should the spectrometer be purchased?
   -Select-YesNo

Answer 1

Calculation of Depreciation:

{1}	{2}	{3}	{4} = {2}*{3}
Year	Cost of Equipment	Depn Rate	Depreciation
1	375,000	33%	123,750
2	375,000	45%	168,750
3	375,000	15%	56,250
			348,750

Book value of Equipment at the end of 3rd year = 375,000 - 348,750

= $26,250

.

Sale value of Equipment at the end of 3rd year = $90,000

.

Profit on sale of Equipment at the end of 3rd year = $90,000 - $26,250

= $63,750

.

Tax on above profit = 63,750*40%

= $25,500

.

After tax salvage value of Equipment at the end of 3rd year = $90,000 - $25,500

= $64,500

.

.

Calculation of Annual Cash Flows & NPV:

{1}	{2}	{3}	{4}	{5} = {4}*(1-Tax Rate) i.e. {4}*0.6	{6}	{7} = {6}*Tax Rate i.e. {6}*0.4	{8}	{9} = {2}+{3}+{5}+{7}+{8}	{10}	{11}	{12} = {9}*{11}
Year	Initial Investmet	Working Capital requirement	Savings in before tax labor costs	Savings in after tax labor costs	Depreciation	Tax Shield on Depreciation	After Tax Salavge Value	Annual Cash Flows	DF Working	Discounting Factor @ 14%	Present Value
0	(375,000)	(9,000)	-	-	-	-	-	(384,000)	1	1	(384,000.00)
1	-	-	78,000	46,800	123,750	49,500	-	96,300	1/1.14^1	0.877192982	84,473.68
2	-	-	78,000	46,800	168,750	67,500	-	114,300	1/1.14^2	0.769467528	87,950.14
3	-	9,000	78,000	46,800	56,250	22,500	64,500	142,800	1/1.14^3	0.674971516	96,385.93
										NPV:	(115,190.24)

.

.

Answer to Part-1:

The initial investment outlay for the spectrometer, that is, the Year 0 project cash flow = Base Price of Equipment + Modification Cost

= $300,000 + $75,000

= $375,000

.

.

Answer to Part-2:

Calculation of Annual Cash Flows:

{1}	{2}	{3}	{4}	{5} = {4}*(1-Tax Rate) i.e. {4}*0.6	{6}	{7} = {6}*Tax Rate i.e. {6}*0.4	{8}	{9} = {2}+{3}+{5}+{7}+{8}
Year	Initial Investmet	Working Capital requirement	Savings in before tax labor costs	Savings in after tax labor costs	Depreciation	Tax Shield on Depreciation	After Tax Salavge Value	Annual Cash Flows
0	(375,000)	(9,000)	-	-	-	-	-	(384,000)
1	-	-	78,000	46,800	123,750	49,500	-	96,300
2	-	-	78,000	46,800	168,750	67,500	-	114,300
3	-	9,000	78,000	46,800	56,250	22,500	64,500	142,800

.

.

Answer to Part-3:

Calculation of NPV:

{1}	{2}	{3}	{4} = {1}*{3}
Annual Cash Flows	DF Working	Discounting Factor @ 14%	Present Value
(384,000)	1	1	(384,000.00)
96,300	1/1.14^1	0.877192982	84,473.68
114,300	1/1.14^2	0.769467528	87,950.14
142,800	1/1.14^3	0.674971516	96,385.93
		NPV:	(115,190.24)

Should the spectrometer be purchased?
Answer -No

.

Reason: NPV from investment in spectrometer is negative , so it should not be purchased.