You must evaluate a proposed spectrometer for the R&D department. The base price
ID: 2764623 • Letter: Y
Question
You must evaluate a proposed spectrometer for the R&D department. The base price is $150,000, 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 $37,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require an $15,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $20,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40%.
a. 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?
b. 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?
c. If the WACC is 11%, should the spectrometer be purchased?
Explanation / Answer
Depreciation Schedule:
Year
Basis
%
Depreciation Expense
Accumulated
Depreciation
Ending
Book Value
1
$150,000.00
33.00%
$49,500.00
$49,500.00
$100,500.00
2
$150,000.00
45.00%
$67,500.00
$117,000.00
$33,000.00
3
$150,000.00
15.00%
$22,500.00
$139,500.00
$10,500.00
4
$150,000.00
7.00%
$10,500.00
$150,000.00
$0.00
Initial investment outlay for spectrometer:
Base Price + Modification cost + Net working capital
=> $150,000 + $30,000 + $15,000 = $195,000
After-tax labor cost savings = $20,000 x (1-tax rate) = $20,000 x 0.60 = $12,000
After-tax salvage value of machine at the end of project
=> ($37,500 - $10,500) x (1-tax rate) = $16,200
Cash Flow Year 1 = After tax savings + Depreciation
= $12,000 + $49,500 = $61,500
Cash Flow Year 2 = After tax savings + Depreciation
= $12,000 + $67,500 = $79,500
Cash Flow Year 3 = After tax savings + Depreciation + After-tax salvage value of machine
= $12,000 + $22,500 + $16,200 = $50,700
NPV = -$195,000 + {$61,500/(1+.11)1} + {$79,500/(1+.11)2} + {$50,700/(1+.11)3} = -$37,999.21
As the NPV at 11% of WACC is negative, the project should not be accepted at this level of WACC.
Year
Basis
%
Depreciation Expense
Accumulated
Depreciation
Ending
Book Value
1
$150,000.00
33.00%
$49,500.00
$49,500.00
$100,500.00
2
$150,000.00
45.00%
$67,500.00
$117,000.00
$33,000.00
3
$150,000.00
15.00%
$22,500.00
$139,500.00
$10,500.00
4
$150,000.00
7.00%
$10,500.00
$150,000.00
$0.00
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