The president of the company you work for has asked you to evaluate the proposed

Question

The president of the company you work for has asked you to evaluate the proposed acquisition of a new chromatograph for the firm’s R&D department. The equipment's basic price is $80,000, and it would cost another $12,000 to modify it for special use by your firm. The chromatograph, which falls into the MACRS 3-year class, would be sold after 3 years for $20,000. The MACRS rates for the first three years are 0.3333, 0.4445, and 0.1481. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,800. The machine would have no effect on revenues, but it is expected to save the firm $32,000 per year in before-tax operating costs, mainly labor. The firm's marginal federal-plus-state tax rate is 40%.

a) What is the Year-0 net cash flow? If the answer is negative, use minus sign.
$  

b) What are the net operating cash flows in Years 1, 2, and 3? Round your answers to the nearest dollar.

c) What is the additional (nonoperating) cash flow in Year 3? Round your answer to the nearest dollar.
$  

d) If the project's after-tax cost of capital is 10%, should the chromatograph be purchased?

Year 1 $   Year 2 $   Year 3 $  

Explanation / Answer

Part 1)

The year 0 cash flow is calculated as follows:

Year 0 Cash Flow = -Initial Investment - Cost of Modification - Working Capital

Using the values provided in the question, we get,

Year 0 Cash Flow = -80,000 - 12,000 - 4,800 = -$96,800

___________

Part B)

The operating cash flow for each year is calculated with the use of following table:

___________

Part C)

Additional non operating cash flow would consist of after-tax salvage value and recovery of net working capital. Relevant formulas are:

Additional Non Operating Cash Flow = After Tax Salvage Value + Return of Net Working Capital

After Tax Salvage Value = Sales Value +/- Tax on Loss/Gain from Sale of Asset

Loss/Gain from Sale of Asset = Sales Value - Book Value

Book Value = (Basic Price + Modification Cost)*(1-(.3333+.4445+.1481))

___________

Using the above mentioned formulas, we get,

Book Value = (80,000 + 12,000)*(1-(.3333+.4445+.1481)) = $6,817

Gain on Sale of Equipment = 20,000 (Sales Value) - 6,817 (Book Value) = $13,183

Tax on Gain = 13,183*40% = $5,273

After Tax Salvage Value = 20,000 - 5,273 = $14,727

___________

Additional (Non Operating) Cash Flow = 14,727 + 4,800 = $19,527

___________

Part D)

We will have to calculate the NPV in order to determine whether chromatograph be purchased or not. The formula for calculating NPV is given below:

NPV = Cash Flow Year 0 + Cash Flow Year 1/(1+Cost of Capital)^1 + Cash Flow Year 2/(1+Cost of Capital)^2 + Cash Flow Year 3/(1+Cost of Capital)^3

___________

Using the values calculated above, we get,

NPV = -96,800 + 31,465/(1+10%)^1 + 35,558/(1+10%)^2 + (24,650 + 19,527)/(1+10%)^3 = -$5,617

No, the chromatograph shouldn't be purchased as it provides a negative NPV.

Operating Cash Flow Year 1 Year 2 Year 3 Savings before Tax 32,000 32,000 32,000 Less Depreciation 30,664 (92,000*.3333) 40,894 (92,000*.4445) 13,625 (92,000*.1481) Savings after Depreciation 1,336 -8,894 18,375 Less Taxes 535 -3,558 7,350 Savings after Taxes 802 -5,336 11,025 Add Depreciation 30,664 40,894 13,625 Operating Cash Flow $31,465 $35,558 $24,650

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