Question

You must evaluate a proposal to buy a new milling machine. The base price is $140,000, and shipping and installation costs would add another $14,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $91,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $10,000 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 $35,000 per year. The marginal tax rate is 35%, and the WACC is 11%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

a. How should the $5,000 spent last year be handled?

1. 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.
2. The cost of research is an incremental cash flow and should be included in the analysis.
3. Only the tax effect of the research expenses should be included in the analysis.
4. 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.
5. 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.

b.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.

c. What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.

d. Should the machine be purchased?

Answer 1

a]

Option 1 is correct

Options 2 and 3 are incorrect - The expenditure was incurred last year, and is not an incremental cash flow because it is not an expense that would be incurred only if the project is accepted. Hence, neither the expenditure nor its tax effect should be considered incremental cash flows, and should be ignored

Option 4 is incorrect - A terminal cash flow is one that occurs at the end of the project

Option 5 is incorrect - An opportunity cost is a cash flow foregone due to accepting the project

b]

Year 0 cash flow = base price + shipping cost + increase in NOWC

Year 0 cash flow = $140,000 + $14,000 + $10,000 = $164,000

c] and d]

Incremental EBIT each year = Savings in pretax costs - depreciation

Operating cash flow (OCF) each year = income after tax + depreciation

Incremental EBIT is negative, and therefore is a tax deductible loss that provides a tax benefit when EBIT is negative.

Book value of machine at end of 3 years = initial cost - total depreciation for 3 years = $154,000 - $50,820 - $69,300 - $23,100 = $10,780

Tax on salvage value = (sale price - book value) * tax rate = ($91,000 - $10,780) * 35% = $28,077

Terminal cash flow = after tax salvage value + return of NOWC

NPV is calculated using NPV function in Excel

NPV is -$13,463

The machine should not be purchased as the NPV is negative