You must evaluate a proposed spectrometer for the R&D; department. The base pric

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 net operating 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 initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? What are the project's annual cash flows in Years 1, 2, and 3? If the WACC is 12%, should the spectrometer be purchased? Explain.

Explanation / Answer

a. what is the net cost of the spectrometer that is the year 0 nat cash flow?

Net cost of spectrometer that is the year 0 nat cash flow = $ 178,000

Working notes for the above answer is as under

.          

                        Price                         ($140,000)

                  Modification              (30,000)

                  Change in NWC          (8,000)

                  Net Cost                     ($178,000)

b. what are the net operating cash flows in year 1,2,3

The after-tax cost savings is $50,000(1 – T)

= $50,000(0.6)

=$30,000

**The depreciation expense in each year is the depreciable basis, $178,000, times the MACRS allowance percentage of 0.33, 0.45, and 0.15 for Years 1, 2 and 3, respectively.

Depreciation expense in Years 1, 2, and 3 and the depreciation shield is calculated as the tax rate (40%) times the depreciation expense in each year is as follow

C

value                                                                     $60,000

                  Tax on SV*                                                                    (19240)

                  Return of NWC                                                                            8,000

                  Additional end-of-project cash flow                                 $48760

Tax on SV = ($60,000 - $11900)(0.4) = $19240.

The remaining Book Value in Year 4 = $170,000(0.07) = $1190.

The project has a negative NPV, therefore it should not be accepted

Year 1 Year 2 Year 3 After-tax savings 30,000 30,000 30,000 Depreciation shield 22440 30600 10200 Operating cash flow 52,440 60,600 40,200

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