Question

You must evaluate a proposed spectrometer for the R&D department. The base price is $190,000, and it would cost another $47,500 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 $57,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $13,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $57,000 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?

Answer 1

See the explanation for the answers.

Step-by-step explanation:

(a)

Year

0 1 2 3

Cost of Equipment= 237500 0 0 0

Base price +

Modification

Cost

Working Capital 13000 0 0 -1300

Saving in 0 57000 57000 57000

Labor Cost

Depreciation(%) 0 33% 45% 15%

Depreciation 0 78375 106875 35625

.Book Value 237500 159125 52250 16625

.Salvage Value 0 0 0 57000

.After Tax 0 0 0 40850

Salvage Value

.Cash Flow -250500 65550 76950 102300

.Discounted Cash -250500 57500 59210.5 69049.59

Flow at 14%

NET VALUE -64739.89

(a)

Initial Investment / Cash Flow in year 0 = Cost of Equipment + Increase in working capital

= 237500 + 13000

=$250,500

Cash Flows in Years 1 and 2 = (Saving in Labor Cost - Depreciation) * (1 - Tax Rate) + Depreciation

Cash Flow in year 3 = (Saving in Labor Cost - Depreciation) * (1 - Tax Rate) + Depreciation + Recovery of Working Capital + After Tax Salvage Value

After Tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * Tax Rate

= 57000 - (57000 - 16625) * 0.4

= $40,850

(b)

Year Cash Flow

1 $65550

2 $76950

3 $102300

(c)

If WACC is 14%, the net present value of the project is -$64,739.89. Since NPV is negative, the barometer should not be purchased.