You must evaluate the purchase of a proposed CAD-CAM equipment for the R&D depar

Question

You must evaluate the purchase of a proposed CAD-CAM equipment for the R&D department. The base price is $630,000, and it would cost another $80,000 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 $150,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $40,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $210,000 per year in before-tax labor costs. The firm’s marginal federal-plus-state tax rate is 35%.

a) What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow?

b) What are the project’s annual cash flows in Years 1, 2, and 3?

c) If the WACC is 6.5%, should the investment be made? Explain.

Explanation / Answer

Details Year 0 Year 1 Year 2 Year 3 Investment in Base cost                (630,000) Cost of Modification                   (80,000) Total Machine cost                  (710,000) Increase in NWC                     (40,000) a Net Cash Flow Year 0                (750,000) MACRS Rate   33% 45% 15% Macchine book value after year 3 @7%                     49,700 Salvage value                     150,000 Capital Gain                     100,300 Tax on Cpital Gain @35%                     35,105 b Annual Cash Flows Year 1-3 Before tax labor cost saving         210,000        210,000      210,000 Less : Depreciation =    (234,300)      (319,500)    (106,500) Taxable income         (24,300)      (109,500)      103,500 Tax @35%           8,505          38,325      (36,225) Post Tax Income       (15,795)        (71,175)        67,275 Add Back depreciation       234,300        319,500      106,500 Annual Cash flow from operations       218,505        248,325      173,775 Terminal Value Yr 3 Salvage        150,000 Less Tax on Capital Gain      (35,105) NWOC return          40,000 Net Treminal Cash flow        154,895 Total Cash Flow                (750,000)       218,505        248,325      328,670 c PV factor @6.5%=                                1           0.939             0.882           0.828 PV of net Cash flows                (750,000)       205,169        218,938      272,089 NPV =                   (53,804) As the NPV is negative, the investment should not be made.

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