A division of a large corporation is considering the purchase of a new tunneling

Question

A division of a large corporation is considering the purchase of a new tunneling X-ray microscope for $370,125. The projected net benefits from gains in materials engineering is projected to be $125,000 in today’s real dollars for the first year, increasing by an arithmetic gradient of $18,500 per year in real dollars for years 2 to 4. The unit will be depreciated under MACRS. Due to increasing advances in tunneling X-ray microscope technology, the unit will have $50,000 market value in today’s real dollars at the end of the 4 year project life. During the 4 year analysis period, inflation is expected to be steady at 3.8% per year. The corporation has a combined state and federal income tax rate of 40.0%. The corporation requires a 15.0% after-tax market rate of return on its research and development investments. Should the X-ray unit be purchased?

Explanation / Answer

Operating cash flows = ( Revenues - expenses - depreciation ) * ( 1-tax rate) + depreciation

Inflation adjusted after tax market rate of return =[ ( 1+0.15) / ( 1+0.0380) ] - 1

Inflation adjusted after tax market rate of return =10.7899%

Net present value = - $ 370 ,125 + 85,000/(1+0.107899)1 + $104,468.0/(1+0.107899)2 + $109,641.6 / (1+0.107899)3 + $116,617.4/ (1+0.107899)4 + $ 50,000 ( salvage value)

Net present value = $4,632.24

The X ray unit should be purchased because the net present value is positive .

Year cash flows Depreciation percentage Depreciation per year Operating cash flows 0 ($370,125) ($370,125) 1 $125,000 20 $25,000 $85,000.0 2 $143,500 32 $45,920 $104,468.0 3 $162,000 19.2 $31,104 $109,641.6 4 $180,500 11.52 $20,794 $116,617.4 11.52 5.76

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