Question

NEW PROJECT ANALYSIS

You must evaluate a proposal to buy a new milling machine. The base price is $104,000, and shipping and installation costs would add another $20,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $57,200. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $4,500 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 $54,000 per year. The marginal tax rate is 35%, and the WACC is 13%. 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.
   
   =______?

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?
   =YES/NO?

Answer 1

a

Time line		0	1	2	3
Cost of new machine		-124000
Initial working capital		-4500
=b. Initial Investment outlay		-128500
3 years MACR rate			33.00%	45.00%	15.00%	7.00%
Savings			54000	54000	54000
-Depreciation	=Cost of machine*MACR%		-40920	-55800	-18600	8680	=Salvage Value
=Pretax cash flows			13080	-1800	35400
-taxes	=(Pretax cash flows)*(1-tax)		8502	-1170	23010
+Depreciation			40920	55800	18600
=c. after tax operating cash flow			49422.00	54630.00	41610
reversal of working capital					4500
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				37180
+Tax shield on salvage book value	=Salvage value * tax rate				3038
=Terminal year after tax cash flows					44718
Total Cash flow for the period		-128500	49422	54630	86328
Discount factor=	(1+discount rate)^corresponding period	1	1.13	1.2769	1.442897
Discounted CF=	Cashflow/discount factor	-128500	43736.283	42783.303	59829.634
NPV=	Sum of discounted CF=	17849.22

d

accept project as NPV is positive