Question

You must evaluate a proposal to buy a new milling machine. The base price is $112,000, and shipping and installation costs would add another $15,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $72,800. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $8,500 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 $50,000 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. How should the $5,000 spent last year be handled? 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. 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. 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?

Answer 1

Calculation of Depreciation
feasibility of using the machine	5000
Base Price	112000
installation	15000
Total cost	132000
Salvage value	72800
Amount to be depreciated	59200

Depreciation
Year 1	59200*33%	19536
Year 2	59200*45%	26640
Year 3	59200*15%	8880
Year 4	59200*7%	4144

Initial investment outlay for the machine for capital budgeting purposes

Base Price of Machine	112000
installation	15000
Working capital	8500
Total	135500

Project's annual cash flows during Years 1, 2, and 3

Year	1	2	3
Pretax labor costs would decline	50000	50000	50000
Less : Depreciation	19536	26640	8880
Profit before tax	30464	23360	41120
tax @ 35%	10662.4	8176	14392
Profit after tax	19801.6	15184	26728
Add : Depreciation	19536	26640	8880
Free cash flow	39337.6	41824	35608

Present value of incremental free cash flow

Year	1	2	3
Free cash flow	39337.6	41824	35608
Present value factor	0.900901	0.811622	0.731191
Present value	35439.28	33945.3	26036.26
Total present value	95420.84

Present Value of terminal cash flow

Salvage value	72800
Working capital	8500
Total	81300
Present value factor	0.731191
Present value	59445.86

Present value of depreciation tax refund of year 4

Depreciation	4144
Tax refund	1450.4
Present value factor	0.658731
Present value	955.42

Total Present value of cash inflow = 95420.84 + 59445.86 + 955.42 = 155822.12

Net Present value = Present value of cash inflows - initial outflow

= 155822.12 - 135500 = 20322.12

Since Net present value at required rate of return is positive the machine should be purchased.

Summary

1.  Initial investment outlay for the machine = 135500

2. Project's annual cash flows during Years 1, 2, and 3

Year	1	2	3
Free cash flow	39337.6	41824.0	35608.0

3. Machine should be purchased