You have been asked by the President of your company to evaluate the proposed ac
ID: 2673005 • Letter: Y
Question
You have been asked by the President of your company to evaluate the proposed acquisition of a new spectrometer for the firm's R&D department. The equipment's basic price is $70,000, and it would cost another $10,750 to modify it for special use by your firm. The spectrometer, which falls into the MARCS 3-year class, would be sold after 3 years for $30,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,000. The spectrometer would have no effect on revenues, but it is expected to save the firm $25,000 per year in before-tax operating costs, mainly labor. The firm's marginal federal-plus-state tax rate is 40%.a. What is the net cost of the spectrometer (i.e., the Year-0 Net Cash Flow)
b. What are the net operating cash flows in Years 1, 2 and 3?
c. What is the additional (non-operating) cash flow in Year 3?
d. If the project's cost of capital is 10%, should the spectrometer be purchased?
e. Being a freshly-minted MBA, you have noticed that interest rates are extremely low, with 10-year money being available at a 4.5% interest rate. This means that you company could issue $60 Million in bonds at their face value (aka par) at 4.5% coupon rates with 10-year maturities. Your firm has 10 million common stock shares outstanding and $80 Million of Total Equity on its Balance Sheet. Your firm's share trade on the stock exchange for $12 per share. The firm currently has no debt on its Balance Sheet. If the firm issued the $60 Million in long-term debt, would the decision on acquisition of the spectrometer change, and if so how?
Explanation / Answer
You have been asked by the President of your company to evaluate the proposed acquisition of a new spectrometer for the firm's R&D department. The equipment's basic price is $70,000, and it would cost another $10,750 to modify it for special use by your firm. The spectrometer, which falls into the MARCS 3-year class, would be sold after 3 years for $30,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,000. The spectrometer would have no effect on revenues, but it is expected to save the firm $25,000 per year in before-tax operating costs, mainly labor. The firm's marginal federal-plus-state tax rate is 40%.
a. What is the net cost of the spectrometer (i.e., the Year-0 Net Cash Flow)
Price ($70,000)
Modification (15,000)
Change in NWC (4,000)
Net Cost ($89,000)
b. What are the net operating cash flows in Years 1, 2 and 3?
Year 1 Year 2 Year 3
*After-tax savings $15,000 $15,000 $15,000
**Depreciation shield 11,220 15,300 5,100
Operating cash flow $26,220 $30,300 $20,100
The after-tax cost savings is $25,000(1 – T) = $25,000(0.6)= = $15,000.
The depreciation expense in each year is the depreciable basis, $85,000, times the MACRS allowance percentage of 0.33, 0.45, and 0.15 for Years 1, 2 and 3, respectively.
Depreciation expense in Years 1, 2, and 3 is $28,050, $38,250, and $12,750. The depreciation shield is calculated as the tax rate (40%) times the depreciation expense in each year.
c. What is the additional (non-operating) cash flow in Year 3?
Salvage value $30,000
Tax on SV* (9,620)
Return of NWC 4,000
Additional end-of-project cash flow $24,380
*Tax on SV = ($30,000 - $5,950)(0.4) = $9,620.
The remaining Book Value in Year 4 = $85,000(0.07) = $5,950.
d. If the project's cost of capital is 10%, should the spectrometer be purchased?
Year
Cash Fow
0
($89,000)
1
$26,220
2
$30,300
3
$44,480
NPV
($6,703.83)
The project has a negative NPV, therefore it should not be accepted
Alternatively, with a financial calculator, input the following: CF0 = -89000, CF1 = 26220, CF2 = 30300, CF3 = 44480, and I = 10 to solve for NPV = -$6,703.83.
Year
Cash Fow
0
($89,000)
1
$26,220
2
$30,300
3
$44,480
NPV
($6,703.83)
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