NEW PROJECT ANALYSIS You must evaluate the purchase of a proposed spectrometer f
ID: 2799699 • Letter: N
Question
NEW PROJECT ANALYSIS You must evaluate the purchase of a proposed spectrometer for the R&D; department. The base price is $90,000, and it would cost another $22,500 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 $36,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment would require a $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 $51,000 per year in before-tax labor costs. The firm's marginal federal plus state tax rate is 0% a. What is the initial investment outlay for the spectrometer, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent. Negative amount should be indicated by a minus sign. 127,500 b. What are the project's annual cash flows in Years 1, 2, and 3? Round your answers to the nearest cent. In Year 1$ In Year 2 $ In Year 3 $ C. If the WACC is 10%, should the spectrometer be purchased?Explanation / Answer
Answer a Calculation of Year 0 Cash flow of the project Base price of Spectrometer -$90,000 Modification cost of spectrometer -$22,500 Increase in working capital -$15,000 Year 0 Cash flow of the Project -$127,500 Answer b Calculation of project annual cash flows Year 1 2 3 Saving in Labour cost $51,000 $51,000 $51,000 Tax @ 40% on above -$20,400 -$20,400 -$20,400 Tax saving due to depreciation @ 40% $14,850 $20,250 $6,750 After tax salvage value of equipment $24,750 Net Cash flows $45,450 $50,850 $62,100 Calculation of depreciation & Tax saving Year capitalised cost of equipment Depreciation rate Depreciation Tax saving @ 40% 1 112500 33% 37125 14850 2 112500 45% 50625 20250 3 112500 15% 16875 6750 104625 Calculation of after tax salvage value of equipment Capitalised cost of equipment $112,500 Less : Accumulated depreciation $104,625 Book value of equipment after 3 years $7,875 Sale Value $36,000 Gain on sale $28,125 Tax on Gain @ 40% $11,250 After Tax salvage value (Sale value - Tax) $24,750 Answer c Calculation of net present value of equipment to decide whether it should be purchased or not? Year Cash flow Discount factor @ 10% Present Value 0 -$127,500 1 -$127,500.00 1 $45,450 0.909090909 $41,318.18 2 $50,850 0.826446281 $42,024.79 3 $62,100 0.751314801 $46,656.65 Net Present Value $2,499.62 As the net present value of cash flows associated with equipment is positive at 10% WACC, hence spectrometer should be purchased.
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