Spectrometer Purchase Analysis: Investment & Cash Flow
Spectrometer Purchase Analysis
Let’s analyze the proposed purchase of a spectrometer for the R&D department. The base price is $140,000, with an additional $30,000 for modifications. The equipment falls into the MACRS 3-year class and will be sold after 3 years for $60,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The equipment requires an $8,000 increase in net operating working capital (spare parts inventory). The project will save the firm $50,000 per year in before-tax labor costs. The firm’s marginal federal plus state tax rate is 35%.
a) Initial Investment Outlay
What is the initial investment outlay for the spectrometer (Year 0 project cash flow)?
b) Annual Cash Flows
What are the project’s annual cash flows in Years 1, 2, and 3?
c) Purchase Decision
If the WACC is 9%, should the spectrometer be purchased? Explain.
Solution
CF0 = -$178,000:
Initial investment outlay at t = 0:
- Price: ($140,000)
- Modification: (30,000)
- CAPEX: ($170,000)
- ΔNOWC: (8,000)
- Initial investment outlay: ($178,000)
b. Project’s Operating Cash Flows:
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| Savings | $50,000 | $50,000 | $50,000 |
| Depreciation | $56,100 | $76,500 | $25,500 |
| EBIT | ($6,100) | ($26,500) | $24,500 |
| Taxes (35%) | ($2,135) | ($9,275) | $8,575 |
| EBIT(1 – T) | ($3,965) | ($17,225) | $15,925 |
| Add Depreciation | $56,100 | $76,500 | $25,500 |
| EBIT(1 –T) + DEP | $52,135 | $59,275 | $41,425 |
Terminal Cash Flows at t = 3:
- Salvage value: $60,000
- Tax on salvage value: $16,835
- AT salvage value: $43,165
- NOWC = Recovery of NOWC: $8,000
Project FCFs = EBIT(1 – T) + DEP – CAPEX – (change in) NOWC: $52,135 $59,275 $92,590
Notes:
- The depreciation expense in each year is the depreciable basis, $170,000, times the MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation expense in Years 1, 2, and 3 is $56,100, $76,500, and $25,500.
- Remaining BV in Year 4 = $170,000(0.07) = $11,900.
- Tax on SV = ($60,000 – $11,900)(0.35) = $16,835.
c.
The project has an NPV of ($8,783). Thus, it should not be accepted.
| Year | Cash Flows | PV @ 9% |
|---|---|---|
| 0 | ($178,000) | ($178,000) |
| 1 | 52,135 | 47,830 |
| 2 | 59,275 | 49,891 |
| 3 | 92,590 | 71,496 |
| NPV | ($8,783) |
Notes:
- The depreciation expense in each year is the depreciable basis, $170,000, times the MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation expense in Years 1, 2, and 3 is $56,100, $76,500, and $25,500.
- Remaining BV in Year 4 = $170,000(0.07) = $11,900.
- Tax on SV = ($60,000 – $11,900)(0.35) = $16,835.
Additional Notes (translated from Spanish):
To calculate depreciation, take 33% in the first year, 45% in the second year, 15% in the third year, and 7% in the fourth year.
Taxes are calculated from the EBIT.
Salvage value is the selling price, as stated in the problem.
Tax on salvage value is calculated by summing all the depreciations from all the years and subtracting the result from the initial price of $170,000. Subtract that number from the salvage value, and multiply the answer by the tax rate given in the problem.