6. Problem 12.08 NEW PROJECT ANALYSIS You must evaluate the purchase of a propos

Question

6. Problem 12.08 NEW PROJECT ANALYSIS You must evaluate the purchase of a proposed spectrometer for the R&D; department. The base price is $290,000, and it would cost another $43,500 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 $87,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $9,000 increase in net operating working capital (spare parts inventory). The project would have no effect on revenues, but it should save the firm $33,000 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. Negative amount should be indicated by a minus sign. 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 10%, should the spectrometer be purchased? Select-

Explanation / Answer

Solution :

a) Initial Investment Outlay = Purchase Price of the asset + Modification Cost of the asset +

Investment in Net Operating Working Capital

= $ 290000 + $ 43500 +$ 9000

= $ 342500

b) Operating Cash Flows =

Tax @ 40%

Working Notes -

Depreciation for year 1 = ($290000+$43500) * 33% = $ 110055

Depreciation for year 2 = ($290000+$43500) * 45% = $ 150075

Depreciation for year 3 = ($290000+$43500) * 15% = $ 50025

c) NPV = Present Value of Cash Inflows - Initial Outlay + Present Value of terminal cash flows

={[$ 63822 * PVIF (10%,1)] + [ $ 79830 * PVIF(10%,2)] + [$ 39810 * PVIF (10%,3)]} - $ 342500 + [$ 70538 * PVIF (10%,3)]

= ($ 63822 * 0.909) + ($ 79830 *0.826) + ($ 39810 * 0.751) - $342500 + ($ 70538*0.751)

= $ 58014 + $ 65940 + $ 29897 - $ 342500 + $ 52974

= ($ 135675)

Decision : As NPV is negative, so the spectometer should not be purchased.

Working Notes -

Terminal Cash Flows = After Tax Salvage Value + Recovery of Net Operating Working Capital

= Salvage Value - Taxes on Gain on Salvage Value + Recovery of Net Operating Working Capital

= $ 87000 - [(Salvage Value- Book Value) * Tax Rate] + $ 9000

= $ 87000 - {[$ 87000 -(Initial Cost - Depreciation for three years)]*0.40} +$ 9000

= $ 87000 - {[$ 87000 -($ 333500 - $110055 - $150075 -$50025)] * 0.40} + $9000

= $ 87000 - [($ 87000 - $ 23345)*0.40] + $ 9000

= $ 87000 - $ 25462 +$ 9000

= $ 70538

Particulars Year 1 (in $) Year 2 (in $) Year 3 (in $) Revenue 0 0 0 - Operating Costs (33000) (33000) (33000) - Depreciation 110055 150075 50025 EBIT (77055) (117075) (17025)

Tax @ 40%

30822 46830 6810 EAT before Interest (46233) (70245) (10215) + Depreciation 110055 150075 50025 Operating Cash Flows 63822 79830 39810

Related Questions

Navigate

• Browse (All)
• Browse 6
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.