You must evaluate the purchase of a spectrometer for the R&D department. The bas
ID: 2733712 • Letter: Y
Question
You must evaluate the purchase of a spectrometer for the R&D department. The base price is $11,000, and it would cost another $100 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 $1,650. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $800 increase in net operating working capital. The project would have no effect on revenues, but it should save the firm $6,000 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 is the project's Free Cash Flow in Year 1? What is the project's Free Cash Flow in Year 2? What is the project's Free Cash Flow in Year 3? If the WACC is 10%, what is the project's NPV?Explanation / Answer
Initial Investment Outlay = Base Price + Modification Cost
= $11000 + $100
= $11100
Project’s Free Cash Flow in Year 1:
Savings in Labor Costs $6000
Less: Taxes (40%) -$2400
Savings after tax $3600
Add: Tax Shield on depreciation $1465.20 (11100 *33% *40%)
Free Cash inflow after tax $5065.20
Less: Requirement of Working capital -$800
Free Cash Flow $4265.20
Project’s Free Cash Flow in Year 2:
Savings in Labor Costs $6000
Less: Taxes (40%) -$2400
Savings after tax $3600
Add: Tax Shield on depreciation $1998 (11100 *45% *40%)
Free Cash inflow after tax $5598
Less: Requirement of Working capital -$800
Free Cash Flow $4798
Project’s Free Cash Flow in Year 3:
Savings in Labor Costs $6000
Less: Taxes (40%) -$2400
Savings after tax $3600
Add: Tax Shield on depreciation $666 (11100 *15% *40%)
Free Cash inflow after tax $4266
Less: Requirement of Working capital -$800
Free Cash Flow $3466
Sale Value of equipment $1650
Less: Tax on gain -$660 ((1650-0)*0.40)
Free Cash Flow $4456
Projects NPV:
Project’s Free Cash Flow in Year 4:
Savings in Labor Costs $6000
Less: Taxes (40%) -$2400
Savings after tax $3600
Add: Tax Shield on depreciation $310.80 (11100 *7% *40%)
Free Cash inflow after tax $3910.80
Less: Requirement of Working capital -$800
Free Cash Flow $3110.80
NPV:
Year
Cash Flow
PVF (10%)
PV of Cash Flow
0
-$11100
1
-$11100
1
$4265.20
0.909
$3877.0668
2
$4798
0.826
$3963.148
3
$4456
0.751
$3346.456
4
$3110.80
0.683
$2124.6764
$2211.3472
NPV = $2211.35
Year
Cash Flow
PVF (10%)
PV of Cash Flow
0
-$11100
1
-$11100
1
$4265.20
0.909
$3877.0668
2
$4798
0.826
$3963.148
3
$4456
0.751
$3346.456
4
$3110.80
0.683
$2124.6764
$2211.3472
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