You must evaluate a proposed spectrometer for the R&D department. The base price
ID: 2716663 • Letter: Y
Question
You must evaluate a proposed spectrometer for the R&D department. The base price is $150,000, and it would cost another $22,500 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 $45,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $14,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $59,000 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?
Explanation / Answer
Initial investment = Base price + Additional cost + Working capital
= $150,000 + $22,500 + $14,000
= $172,500 + $14,000
= $186,500
Annual cash flow in year 1 = {Saving amount × (1 – tax rate)} + 33% depreciation
= {$59,000 × (1 – 0.40)} + (0.33 × $172,500)
= $35,400 + $56,925
= $92,325
Annual cash flow in year 2 = {Saving amount × (1 – tax rate)} + 45% depreciation
= {$59,000 × (1 – 0.40)} + (0.45 × $172,500)
= $35,400 + $77,625
= $113,025
Annual cash flow in year 3 = {Saving amount × (1 – tax rate)} + 15% depreciation + Recovery of working capital + {(Salvage value – 7% depreciation) × (1 – tax rate)}
= {$59,000 × (1 – 0.40)} + (0.15 × $172,500) + $14,000 + {($45,000 – 0.07 × $172,500) × (1 – 0.40)}
= $35,400 + $25,875 + $14,000 + $19,755
= $95,030
NPV table is as below:
Year
Cash flow
14% discount factor
Present value
0
-186,500
1
-186,500
1
92,325
0.8772
80,987.49
2
113,025
0.7695
86,972.74
3
95,030
0.6750
64,145.25
NPV
45,605.48
Since NPV ($45,605.48) is positive, the project should be accepted and the equipment should be purchased.
Year
Cash flow
14% discount factor
Present value
0
-186,500
1
-186,500
1
92,325
0.8772
80,987.49
2
113,025
0.7695
86,972.74
3
95,030
0.6750
64,145.25
NPV
45,605.48
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