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 $160,000, and it would cost another $32,000 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 $80,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $6,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $29,000 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? Round your answer to the nearest cent.

b. What are the project's annual cash flows in Years 1, 2, and 3? Round your answers to the nearest cent.

c. If the WACC is 14%, should the spectrometer be purchased?

Explanation / Answer

a. Year 0 project cash flow = base price+modification amount+increase in net operating working capital

= 160,000+32,000+6,000 = $198,000

b. Annual cash flows = net operating cash flow. Net operating cash flow = savings*(1-tax rate)+tax shield on depreciation.

tax shield on depreciation = depreciation amount*tax rate

depreciation amount = depreciation rate for a given year*(base price of sprectometer+modification cost) = depreciation rate for a given year*(160,000+32,000) = depreciation rate for a given year*192,000

Also in the 3rd year, salvage value = $80,000. After tax amount of salvage value = (1-40%)%80,000 = $48,000. Return of working capital invested = 6,000.

Thus, net cash flow for the 3rd year = cash flow as calulated in the table+after tax salvage value+return of working capital invested = 28920+48000+6000 = $82,920

c. The cash flows will be discounted using the formula: cash flow amount/(1+wacc)^n

As the NPV is negative, the spectrometer should not be purchased.

Year 1 2 3 Before tax savings 29,000.00 29,000.00 29,000.00 Tax rate 0.4 After tax savings 17,400.00 17,400.00 17,400.00 Depreciation rate 0.33 0.45 0.15 Depreciation amount 63,360.00 86,400.00 28,800.00 Tax shield on depreciation 25,344.00 34,560.00 11,520.00 Net operating cash flow (after tax savings+tax shield) 42,744.00 51,960.00 28,920.00

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