Question

Click here to read the eBook: Analysis of an Expansion Project NEW PROJECT ANALYSIS You must evaluate a proposal to buy a new milling machine. The base price is $123,000, and shipping and installation costs would add another $17,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $79,950. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $5,000 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 $55,000 per year. The marginal tax rate is 35%, and the WACC is 14%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine. How should the $5,000 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 as 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 as 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. -Select-IIIIIIIVVItem 1 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. $ 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 $ Should the machine be purchased? -Select-YesNo

Answer 1

Initial Investment = Base Price + Modification Cost
Initial Investment = $123,000 + $17,000
Initial Investment = $140,000

Useful Life = 3 years

Depreciation Year 1 = 33% * $140,000
Depreciation Year 1 = $46,200

Depreciation Year 2 = 45% * $140,000
Depreciation Year 2 = $63,000

Depreciation Year 3 = 15% * $140,000
Depreciation Year 3 = $21,000

Book Value at the end of Year 3 = $140,000 - $46,200 - $63,000 - $21,000
Book Value at the end of Year 3 = $9,800

After-tax Salvage Value = Salvage Value - (Salvage Value - Book Value) * tax rate
After-tax Salvage Value = $79,950 - ($79,950 - $9,800) * 0.35
After-tax Salvage Value = $55,397.50

Initial Investment in NWC = $5,000

Answer a.

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.

Answer b.

Year 0:

Net Cash Flows = Initial Investment + Initial Investment in NWC
Net Cash Flows = -$140,000 - $5,000
Net Cash Flows = -$145,000

Answer b.

Year 1:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $55,000 * (1 - 0.35) + 0.35 * $46,200
Operating Cash Flow = $51,920

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $51,920

Year 2:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $55,000 * (1 - 0.35) + 0.35 * $63,000
Operating Cash Flow = $57,800

Net Cash Flows = Operating Cash Flow
Net Cash Flows = $57,800

Year 3:

Operating Cash Flow = Pretax Cost Saving * (1 - tax) + tax * Depreciation
Operating Cash Flow = $55,000 * (1 - 0.35) + 0.35 * $21,000
Operating Cash Flow = $43,100

Net Cash Flows = Operating Cash Flow + NWC recovered + After-tax Salvage Value
Net Cash Flows = $43,100 + $5,000 + $55,397.50
Net Cash Flows = $103,497.50

Answer c.

WACC = 14%

NPV = -$145,000 + $51,920/1.14 + $57,800/1.14^2 + $103,497.50/1.14^3
NPV = $14,876.95

Yes, the machine should be purchased as NPV is positive.