Question

You must evaluate a proposal to buy a new milling machine. The base price is $161,000, and shipping and installation costs would add another $20,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $80,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $9,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $39,000 per year. The marginal tax rate is 35%, and the WACC is 12%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

1. How should the $5,000 spent last year be handled?
   1. The cost of research is an incremental cash flow and should be included in the analysis.
   2. Only the tax effect of the research expenses should be included in the analysis.
   3. Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.
   4. Last year's expenditure is considered as an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
   5. Last year's expenditure is considered as a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
   
   -Select-IIIIIIIVVItem 1

2. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.
   $

3. What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent. Do not round your intermediate calculations.

   Year 1 $

   Year 2 $

   Year 3 $

4. Should the machine be purchased?
   -Select-YesNo

Answer 1

a.V.Sunk cost and does not represent incremental cash flow and should not be included

a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital

= -161,000-20,000-9,500

= -$190,500

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	39,000	39,000	39,000
Less: Depreciation	59,730	81,450	27,150
Net Savings	-20,730	-42,450	11,850
Less: Tax @35%	-7,255.50	-14,857.50	4,147.50
Income after Tax	-13,474.50	-27,592.50	7,702.50
Add: Depreciation	59,730	81,450	27,150
Cash Flow	46,255.50	53,857.50	34,852.50
Add: After tax salvage value			56,759.50
Recovery of Working capital			9,500
Cash Flow	46,255.50	53,857.50	101,112

Note: Written down value of machine = 181,000*7% = $12,670

Sale Price = $80,500

Gain on Sale = $67,830

Tax on Gain = $23,740.5

After tax salvage value = 80,500 – 23,740.5 = $56,759.5

c.NPV = Present value of cash inflows – present value of cash outflows

= 46,255.5*PVF(12%, 1 year) + 53,857.5*PVF(12%, 2 years) + 101,112*PVF(12%, 3 years) – 190,500

= 46,255.5*0.893 + 53,857.5*0.797 + 101,112*0.712 – 190,500

= -$34,277.67

No, should not be purchased (since NPV is negative)