Question

You must evaluate a proposal to buy a new milling machine. The base price is $120,000, and shipping and installation costs would add another $6,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $48,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $4,000 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 $57,000 per year. The marginal tax rate is 35%, and the WACC is 8%. Also, the firm spent $4,500 last year investigating the feasibility of using the machine. How should the $4,500 spent last year be handled? 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. Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. The cost of research is an incremental cash flow and should be included in the analysis. Only the tax effect of the research expenses should be included in the analysis. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest cent. $ What are the project's annual cash flows during Years 1, 2, and 3? Do not round intermediate calculations. Round your answers to the nearest cent. Year 1: $ Year 2: $ Year 3: $ Should the machine be purchased?

Answer 1

How should the $4,500 spent last year be handled?

The correct answer is: Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

Last year's cash flow is already incurred, can't be reversed and is no longer dependent upon our decision to go ahead or reject. Hence, it's a sunk cost and hence irrelevant for capital budgeting.

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What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest cent.

Initial investment, C₀ = Base price + shipping and installation costs + increase in net operating working capital = 120,000 + 6,000 + 4,000 = $ 130,000.00

$ What are the project's annual cash flows during Years 1, 2, and 3? Do not round intermediate calculations. Round your answers to the nearest cent. Year 1: $ Year 2: $ Year 3: $ Should the machine be purchased?

The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $48,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%.

Depreciable basis = Base price + shipping and installation costs = 126,000

Undepreciated tax basis at the end of year 3 = 126,000 x 7% = 8,820

Salvage value = 48,000

Gain on sale = 48,000 - 8,820 = 39,180

Post tax salvage value = Salvage value - tax on gain on sale= 48,000 - 35% x 39,180 = $  34,287

Please see the table below now. Please be guided by the second column titled “Linkage” to understand the mathematics. The cells highlighted in yellow contain the cash flows for year 1, 2 and 3. They are part of your answers. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

NPV = $ 31,614.99 as shown in the last row highlighted in green color.

Since, the machine has positive NPV, hence the machine should be purchased.