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 $90,000, and it would cost another $18,000 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 $31,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $12,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $44,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.

a. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow?

b. What are the project's annual cash flows in Years 1, 2, and 3?

c.If the WACC is 12%, should the spectrometer be purchased?

Explanation / Answer

Initial investment = 90,000 + 18,000 + 12,000 = 120,000

Cash flow generated each year = 44,000

MACRS depreciation method will depreciate machine with 33%, 45%, 15% and 7% in the first 4 years respectively

Year 0 cash flow = -90000 - 18000 - 12000 *(1-40%) = 115,200

Salvage value = 90000 * 7% = 6300

Market value of machine at the end of year 3 = 31500

Gain = 31500 - 6300 = 25,200

After tax value of gain is added in the year 3 cash flow below

Cash flows of this project are calculated in the table below

NPV = NPV(12%,A1:A3)-115,200 = -13,664.24

Should not purchase since NPV is negative

Cash flow Tax Rate After tax Cash Flow Machine Depreciation value Depreciation Tax Shield Salvage value gain Total net cash flows Year 0           (120,000.00) 40%         (120,000.00)                        -                             -                           -        (115,200.00) Year 1                44,000.00 40%             26,400.00         29,700.00            11,880.00                         -             38,280.00 Year 2                44,000.00 40%             26,400.00         40,500.00            16,200.00                         -             42,600.00 Year 3                44,000.00 40%             26,400.00         13,500.00              5,400.00          25,200.00           46,920.00

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