You must evaluate a proposed spectrometer for the R&D department. The base price

Question

You must evaluate a proposed spectrometer for the R&D department. The base price is $220,000, and it would cost another $44,000 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 $55,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $7,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $50,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.

Explanation / Answer

(1)

initial cost of equipemnt = -220,000 -44,000 = -264,000

OCF of year 0 = initial cost of equipemnt + working capital = -264,000 -7,000 = -271,000

(2)

OCF of year 1 = aftertax costs saving + depreciation tax shield = 50,000*(1-40%) + 264,000*33%*40% = 64,848

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OCF of year 2 = aftertax costs saving + depreciation tax shield = 50,000*(1-40%) + 264,000*45%*40% = 77,520

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book value of the equipemnt at year 3 = 264,000 * (1-33%-45%-15%) = 18,480

the equipemnt would be sold for $55,000 at year 3

tax = (55,000 - 18,480)*40% = 14,608

aftertax salvage value of the equipemnt = 55,000 - 14,608 = 40,392

OCF of year 2 = aftertax costs saving + depreciation tax shield + aftertax salvage value + working captical returned = 50,000*(1-40%) + 264,000*15%*40% + 40,392 + 7,000 = 93,232

(3)

NPV = -264,000 + 64,848/(1+11%) + 77,520/(1+11%)^2 + 93,232/(1+11%)^3 = -74,490.97

As the NPV of the equaipment is negative, it should not be purchased.

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