Question

NEW PROJECT ANALYSIS

You must evaluate a proposal to buy a new milling machine. The base price is $118,000, 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 $64,900. 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 $44,000 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. Only the tax effect of the research expenses should be included in the analysis.
   2. 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.
   3. 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.
   4. 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.
   5. The cost of research is an incremental cash flow and should be included in the analysis.
   
   -Select-IIIIIIIVV

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.IV.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

= 118,000+6,000 +9,500

= -$133,500 since outflow

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	44,000	44,000	44,000
Less: Depreciation	40,920	55,800	18,600
Net Savings	3,080	(11,800)	25,400
Less: Tax @35%	1,078	(4,130)	8,890
Income after Tax	2,002	(7,670)	16,510
Add: Depreciation	40,920	55,800	18,600
Cash Flow	42,922	48,130	35,110
Add: After tax salvage value			45,223
Recovery of Working capital			9,500
Cash Flow	42,922	48,130	89,833

Note: Written down value of machine = 124000*7% = $8,680

Sale Price = $64,900

Gain on Sale = $56,220

Tax on Gain = $19,677

After tax salvage value = 64,900– 19,677= $45,223

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

= 42,922*PVF(12%, 1 year) + 48,130*PVF(12%, 2 years) + 89,833*PVF(12%, 3 years) – 133,500

= 42,922*0.893 + 48,130*0.797 + 89,833*0.712 – 133,500

= $7,150.052

Yes, should not be purchased (since NPV is positive)