Question

You must evaluate a proposed spectrometer for the R&D department. The base price is $190,000, and it would cost another $47,500 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 $57,000. 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 $57,000 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.
$

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 14%, should the spectrometer be purchased?

Answer 1

Answer:

See the explanation for the answers.

Explanation:

(a)

                                                     Year

                                        0                      1                   2             3

Cost of Equipment=   237500              0                   0            0

Base price +

Modification

Cost

Working Capital          13000             0                 0           -1300

Saving in                        0               57000         57000      57000

Labor Cost

Depreciation(%)            0              33%               45%            15%

Depreciation                 0             78375           106875      35625

.Book Value            237500       159125           52250         16625

.Salvage Value            0                  0                  0               57000

.After Tax                     0                  0                  0               40850

Salvage Value  

.Cash Flow           -250500         65550         76950         102300

.Discounted Cash -250500     57500          59210.5    69049.59

Flow at 14%  

NET VALUE                -64739.89            

(a)

Initial Investment / Cash Flow in year 0   = Cost of Equipment + Increase in working capital

                               = 237500 + 13000

                               =$250,500

Cash Flows in Years 1 and 2   = (Saving in Labor Cost - Depreciation) * (1 - Tax Rate) +  Depreciation

Cash Flow in year 3   = (Saving in Labor Cost - Depreciation) * (1 - Tax Rate) + Depreciation + Recovery of Working Capital + After Tax Salvage Value

After Tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * Tax Rate

                                        = 57000 - (57000 - 16625) * 0.4

                                       = $40,850

(b)

Year       Cash Flow

1         $65550

2         $76950

3         $102300

(c)

If WACC is 14%, the net present value of the project is -$64,739.89. Since NPV is negative, the barometer should not be purchased.