Keller Fi515 Week 5 Project Solution

You have been asked by the president of your company to evaluate the proposed acquisition of a new spectrometer for the firm’s R&D department. The equipment’s basic price is $70,000, and it would cost another $15,000 to modify it for special use by your firm. The spectrometer, which falls into the MACRS 3-year class, would be sold after 3 years for $30,000. Use of the equipment would require an increase in net working capital (spare parts inventory) of $4,000. The spectrometer would have no effect on revenues, but it is expected to save the firm $25,000 per year in before-tax operating costs, mainly labor. The firm’s marginal federal-plus-state tax rate is 40%.

a. What is the net cost of the spectrometer? (That is, what is the Year-0 net cash flow?)

In year 0 the net cost or net cash flow of the spectrometer project is equal to the capital outlays, therefore

Year 0 cash flow =-( $70000 + $15000 + $4000)

= -$89000

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

Depreciation : MACRS 3 years

NET CASH FLOW = NET INCOME + DEPRECIATION

Net income for each year is simply the cost savings realized by the investment adjusted for the tax rate since it has no affect on revenues but just generates savings:

So the savings in each year is 25000. The tax rate is given at 40%

Adjusting for the tax rate = (1 - .40) X 25000

= 15000 which is the net income in each year

To find the depreciation base we need the total cost to acquire the spectrometer, therefore:

Cost + modification = base

70000 + 15000 = 85000

According to MACRS text table 11-A-2 in the text page 469:

Depreciation year 1 = 33%

Depreciation year 2 = 45%

Depreciation year 3 = 15%

Therefore year 1 = .33 X 85000 = 28050

Year 2 = .45 X 85000 = 38250

Year 3 = .15 X 85000 = 12,750

Depreciation is a non cash expense although the tax shield it provides represents a positive cash flow, therefore we apply the tax rate to the...