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 $190,000, and it would cost another $47,500 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 $47,500. 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 $9,500. The machine would have no effect on revenues, but it is expected to save the firm $76,000 per year in before-tax operating costs, mainly labor. The firm's marginal federal-plus-state tax rate is 30%.a. What is the Year-0 net cash flow?

b. What are the net operating cash flows in Years 1, 2, and 3?

Year 1 $
Year 2 $
Year 3 $
c. What is the additional (nonoperating) cash flow in Year 3?

d. If the project's cost of capital is 14%, should the chromatograph be purchased?

Answer 1

To evaluate a new chromatograph's acquisition, calculate the Year-0 net cash flow, which is the sum of the cost, modification, and increase in net working capital. Then, find the net operating cash flows for Years 1-3 by adjusting annual savings for taxes and depreciation. Finally, compute the nonoperating cash flow for Year 3 including the salvage value and recapture of working capital.

Step-by-step explanation:

Assessing the acquisition of a new chromatograph involves analyzing various cash flows associated with the investment. The following are calculations based on the provided information:

a. Year-0 Net Cash Flow

The Year-0 net cash flow is the sum of the cost of the chromatograph, the cost to modify it, and the increase in net working capital. This results in:
- $190,000 (cost of the equipment)
- $47,500 (modification costs)
- $9,500 (working capital increase)
= $247,000 (total initial outlay)

b. Net Operating Cash Flows in Years 1, 2, and 3

The operating cash flows are derived from the cost savings of $76,000 annually adjusted for taxes and depreciation. Here's the calculation for each year:

• Year 1: ($76,000 - ($76,000 * 0.3333 * 30%)) * (1 - 30%)
• Year 2: ($76,000 - ($76,000 * 0.4445 * 30%)) * (1 - 30%)
• Year 3: ($76,000 - ($76,000 * 0.1481 * 30%)) * (1 - 30%)

c. Additional (Nonoperating) Cash Flow in Year 3

The additional cash flow in Year 3 includes the salvage value of $47,500 plus the recapture of net working capital, offset by taxes on the salvage value.

d. Investment Decision

To determine whether to purchase the chromatograph, we compare the present value of the cash flows against the initial outlay, using the project's 14% cost of capital (discount rate).

Answer 2

Part A)

Year 0 net cash flow would comprise of basic price, modification cost and requirement for net working capital. The formula for cash flow in Year 0 would be:

Year 0 Net Cash Flow = -Basic Price - Modification Cost - NWC

______________

Using the values provided in the question, we get,

Year 0 Net Cash Flow = -190,000 - 47,500 - 9,500 = -$247,000

______________________

Part B:

Year 1, 2 and 3 would required adjustment for depreciation charges (under MACRS) against expected savings. The depreciation rates for 3 year class asset would be 33%, 45% and 15% for Year 1, Year 2 and Year 3 respectively.

Depreciation would be calculated on the equipment's basic price and modification cost.

The formula that can be used to calculate the net operating cash flow would be:

Net Operating Cash Flow = (Sales - Depreciation)*(1-Tax Rate) + Depreciation

______________

Using the values provided in the question, we get, the table in the attached file

Important Information:

Depreciation (Year 1) = (190,000 + 47,500)*33% = $78,375

Depreciation (Year 2) = (190,000 + 47,500)*45% = $106,875

Depreciation (Year 3) = (190,000 + 47,500)*15% = $35,625

______________________

Part C:

Additional non operating cash flow would consist of after-tax salvage value and return 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-(33%+45%+15%))

______________

Using the above mentioned formulas, we get,

Book Value = (190000 + 47500)*(1-(33%+45%+15%)) = $16,625

Gain on Sale of Equipment = 66,500 - 16,625 = $49,875

Tax on Gain = $49,875*30% = $14,962.50

After Tax Salvage Value = 66,500 - 14,962.50 = $51,537.50

_____________________

Additional (Non Operating) Cash Flow = $51,537.50 + $9,500 = $61,037.50 or $61,038

Step-by-step explanation: