The base price of a spectrometer is $140,000, and shipping and installation costs would add another $30,000. The machine falls into the MACRS 3-year class (33%, 45%, 15% and 7%) and it would be sold after 3 years for $60,000.

The machine would require a $8,000 increase in working capital (increased inventory less increased accounts payable).

There would be no effect on revenues, but pre-tax labor costs would decline by $50,000 per year.

The marginal tax rate is 40%, and the WACC is 12%.

1. What is the initial investment outlay, that is, the Year 0 project cash flow?

2. What are the net operating cash flows during Years 1, 2, and 3?

3. Should the machine be purchased? Explain your answer.

Answer and Explanation:

A.) The net cost of the spectrometer is 170,000 (140,000 plus 30,000)

The Year 0 project cash flow is 178,000. (170,000 plus spare parts inventory of 8000)

B.) Project Net cash flow Year 1 is: $45587

Cost saving before tax 50000

Less Depreciation 36300 (170,000 minus salvage value 60,000) x. 33 = 36,300)

Less Amortization Spare Parts 2667 (8000 divided by 3 = 2667)

Net Income after depreciation/amortization 11033

Income Tax 40% 4413

Net Income after Tax 6620

Add: non cash charges depreciation/amortization 38967

Cash flow generated year 1 45587

Project Net cash flow Year 2 is: $ 50867

Cost saving before tax 50000

Less Depreciation 49500 (170,000 minus salvage value 60,000) x. 45 = 49500)

Less Amortization Spare Parts 2667 (8000 divided by 3 = 2667)

Net Income/loss after depreciation/amortization - 2167

Income Tax shield on loss 40% 867

Net Income/loss after Tax shield - 1300

Add: non cash charges depreciation/amortization 52167

Cash flow generated year 2 50867

Project Net cash flow Year 3 is: $ 76747

Cost saving before tax 50000

Less Depreciation 16500 (170,000 minus salvage value 60,000) x. 15 = 16500)

Less Amortization Spare Parts 2667 (8000 divided by 3 = 2667)

Net Income after depreciation/amortization 30833

Gain onSale of equipment at year 3 52300 ($ 60000 minus book value of equipment7700)

Total Income 83133

Income Tax 40% 33253

Net Income after Tax 49880

Add: non cash charges depreciation/amortization 19167

Total income after tax 69l047

add: Sale of equipment book value 7700

Cash flow Generated Year 3 76747

C.) Based on Net Present value of the cash flow discounted at 12%, the spectrometer should not be purchased as the NPV is negative at $-42120

cash flow year 0 - 178000 x 1.0 Present value factor of $1 at 12% at year 0 = - 178000

Cash flow year 1 45587 x 0.892857143 = 40702

Cash Flow year 2 50867 x0.797193878 = 40551

Cash Flow year 3 76747 x 0.711780248 = 54627

Net Present value $ - 42120

Present value factor at 12% at end of year 1 = 1/1.12=0.892857143

Present value factor of 12% at end of year 2 = 0.892857143/1.12=0.797193878

Present value factor of 12% at end of year 3 = 0.797193878/1.12=0.711780248