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 $140,000, and it would cost another $30,000 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 $60,000. The applicable depreciation rates are 33%, 45%, 15%, and 7% as discussed in Appendix 12A. The equipment would require an $8,000 increase in working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $50,000 per year in before-tax labor costs. The firm’s marginal federal-plus-state tax rate is 40%.
What is the net cost of the spectrometer; that is, what is the Year 0 project cash flow?
What are the project’s annual net cash flows in Years 1, 2, and 3?
If the WACC is 12%, should the spectrometer be purchased? Explain.

Explanation / Answer

a. The net cost of the spectrometer is 170,000 ( 140,000 plus 30,000) The Year 0 project cash flow is 178,000. ( 170,000 plus spare parts inventory of 8000) b. Project Net cash flow Year 1 is: $45587 Cost saving before tax 50000 Less Depreciation 36300 ( 170,000 minus salvage value 60,000) x .33 =36,300) Less Amortization Spare Parts 2667 ( 8000 divided by 3 =2667) Net Income after depreciation/amortization 11033 Income Tax 40% 4413 Net Income after Tax 6620 Add: non cash charges depreciation/amortization 38967 Cash flow generated year 1 45587 Project Net cash flow Year 2 is: $ 50867 Cost saving before tax 50000 Less Depreciation 49500 ( 170,000 minus salvage value 60,000) x .45 = 49500 ) Less Amortization Spare Parts 2667 ( 8000 divided by 3 =2667) Net Income/loss after depreciation/amortization -2167 Income Tax shield on loss 40% 867 Net Income/loss after Tax shield -1300 Add: non cash charges depreciation/amortization 52167 Cash flow generated year 2 50867 Project Net cash flow Year 3 is: $ 76747 Cost saving before tax 50000 Less Depreciation 16500 ( 170,000 minus salvage value 60,000) x .15 =16500) Less Amortization Spare Parts 2667 ( 8000 divided by 3 =2667) Net Income after depreciation/amortization 30833 Gain onSale of equipment at year 3 52300 ( $ 60000 minus book value of equipment7700) Total Income 83133 Income Tax 40% 33253 Net Income after Tax 49880 Add: non cash charges depreciation/amortization 19167 Total income after tax 69l047 add: Sale of equipment book value 7700 Cash flow Generated Year 3 76747 c. Based on Net Present value of the cash flow discounted at 12%, the spectrometer should not be purchased as the NPV is negative at $-42120 cash flow year 0 -178000 x 1.0 Present value factor of $1 at 12% at year 0= -178000 Cash flow year 1 45587 x 0.892857143 =40702 Cash Flow year 2 50867 x0.797193878= 40551 Cash Flow year 3 76747 x 0.711780248= 54627 Net Present value $ -42120 Present value factor at 12% at end of year 1 = 1/1.12=0.892857143 Present value factor of 12% at end of year 2 =0.892857143/1.12=0.797193878 Present value factor of 12% at end of year 3 =0.797193878/1.12=0.711780248

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