New project analysis You must evaluate a proposed spectrometer for the R&D; depa

Question

New project analysis You must evaluate a proposed spectrometer for the R&D; department. The base price is $220,000, and it would cost another $33,000 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 $110,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. 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 $51,000 per year in before-tax labor costs. The firm's marginal federal-plus-state tax rate is 40% a. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent. b. What are the project's annual cash flows in Years 1, 2, and 37 Round your answers to the nearest cent. n Year 1$ in Year 2 $ in Year 3$ c. If the WACC is 12%, should the spectrometer be purchased? no

Explanation / Answer

a) Initial Investment = Cost of equipment + Investment In Net Working capital

= ($220000 + $33000) + $8000

= $253000 + $8000

= $261000

b) Annual Cash Flow for Year-1 = Cost Saving x (1-Tax rate) + Depreciation x Tax Rate

= $51000 x (1-0.40) + $253000 x 33% x 40%

= $30600 + $33396

= $63996

Annual Cash Flow for Year-2 = Cost Saving x (1-Tax rate) + Depreciation x Tax Rate

= $51000 x (1-0.40) + $253000 x 45% x 40%

= $30600 + $45540

= $76140

Annual Cash Flow for Year-3 = Cost Saving x (1-Tax rate) + Depreciation x Tax Rate + Release of working capital + Salvage value - Tax on profit on sale of equipment

= $51000 x (1-0.40) + $253000 x 15% x 40% + $8000 + $110000 + ($110000 - $253000 x 7%) x 40%

= $30600 + $15180 + $8000 + $110000 - $36916

= $126864

c) NPV = $63996 x 1/(1.12)^1 + $76140 x 1/(1.12)^2 + $126864 x 1/(1.12)^3 - $261000

= $57139.29 + $60698.34 + $90299.29 - $261000

= ($52863.08)

As the NPV is negative thus the spectrometer should not be purchased.

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