Question

NEW PROJECT ANALYSIS

You must evaluate a proposal to buy a new milling machine. The base price is $125,000, and shipping and installation costs would add another $18,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $50,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $4,500 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 $32,000 per year. The marginal tax rate is 35%, and the WACC is 13%. 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. 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.
   2. 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.
   3. The cost of research is an incremental cash flow and should be included in the analysis.
   4. Only the tax effect of the research expenses should be included in the analysis.
   5. 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.
   
   -Select-IIIIIIIVV    Answer: II ?

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.
   $ 147500.00

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: No?

Answer 1

a.II.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

= -125,000-18,000-4,500

= -$147,500

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	32,000	32,000	32,000
Less: Depreciation	47,190	64,350	21,450
Net Savings	-15,190	-32,350	10,550
Less: Tax @35%	-5,316.5	-11,322.5	3,692.5
Income after Tax	-9,873.5	-21,027.5	6,857.5
Add: Depreciation	47,190	64,350	21,450
Cash Flow	37,316.5	43,322.5	28,307.5
Add: After tax salvage value			36,003.5
Recovery of Working capital			4,500
Cash Flow	37,316.5	43,322.5	68,811

Note: Written down value of machine = 143,000*7% = $10,010

Sale Price = $50,000

Gain on Sale = $39,990

Tax on Gain = $13,996.5

After tax salvage value = 50,000 – 13,996.5 = $36,003.5

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

= 37,316.5*PVF(13%, 1 year) + 43,322.5*PVF(13%, 2 years) + 68,811*PVF(13%, 3 years) – 147,500

= 37,316.5*0.885 + 43,322.5*0.783 + 68,811*0.693 – 147,500

= -$32,859.2

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