You’re evaluating a new electr

You’re evaluating a new electron microscope for the QA (qualityassurance) unit. The microscope will cost $19,000 to buy andanother $2,000 to install, and will be sold for $1,800 after 3years. It falls into the 3-year MACRS class, with depreciationrates as follows:

Year 1 2 3 4
Depreciation rate 33% 45% 15% 7%

The microscope will require an inventory of spare parts worth$5,000. The equipment will not increase revenue, but will save thecompany $10,000 in labor costs each year.

Your company’s marginal tax rate (federal plus state) is 34% andits weighted average cost of capital is 8%.

What is the initial (year-0) free cash flow from the project?Choose the right sign.

What is the free cash flow in year 1?

What is the free cash flow in year 2?

What is the after-tax salvage value of the equipment at the endof year 3?What is the free cash flow in year 3?

What is the NPV of this project?


The initial (year-0) free cash flowfrom the project
Cost of microscope -$19,000.00
Installation cost -$2,000.00
Investment in spare parts -$5,000.00
Cash flow at Year 0 -$26,000.00
The free cash flow in year1
Saving in labor cost $10,000.00
Tax @ 34% on saving -$3,400.00
Depreciation tax shield $2,356.20
Cash flow in Year 1 $8,956.20
The free cash flow in year2
Saving in labor cost $10,000.00
Tax @ 34% on saving -$3,400.00
Depreciation tax shield $3,213.00
Cash flow in Year 2 $9,813.00
Calculation of the after-tax salvagevalue of the equipment at the end of year 3
Salvage value $1,800.00
Less : Book value $1,470.00
Gain on sale $330.00
Tax on Gain @ 34% $112.20
After tax salvage value (Salevalue – Tax) $1,687.80
The free cash flow in year3
Saving in labor cost $10,000.00
Tax @ 34% on saving -$3,400.00
Depreciation tax shield $1,071.00
After Tax salvage value $1,687.80
Cash flow in Year 3 $9,358.80
Calculation of NPV ofproject
Year Cash flow Discount factor @ 8% Present Value
0 -$26,000.00           1.00000 -$26,000.00
1 $8,956.20           0.92593 $8,292.78
2 $9,813.00           0.85734 $8,413.07
3 $9,358.80           0.79383 $7,429.32
NPV -$1,864.84
Calculation of depreciation taxshield
Year Depreciable Value of microscope Depreciation rate Depreciation Depreciation Tax shield @ 34%
1 $21,000.00 33% $6,930.00 $2,356.20
2 $21,000.00 45% $9,450.00 $3,213.00
3 $21,000.00 15% $3,150.00 $1,071.00
4 $21,000.00 7% $1,470.00 $499.80
Book value of microscope atthe end of 3rd year = Cost – accumulated depreciation
Book value of microscope atthe end of 3rd year = $21000 – $19530 = $1470

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