Question

You must evaluate a proposal to buy a new milling machine. The base price is $165,000, and shipping and installation costs would add another $12,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $82,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $8,000 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 $31,000 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. The cost of research is an incremental cash flow and should be included in the analysis.
   2. Only the tax effect of the research expenses should be included in the analysis.
   3. 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.
   4. 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.
   5. 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. 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?

Answer 1

a

Time line		0	1	2	3
Cost of new machine		-177000
Initial working capital		-8000
=b. Initial Investment outlay		-185000
3 years MACR rate			33.00%	45.00%	15.00%	7.00%
Savings			31000	31000	31000
-Depreciation	=Cost of machine*MACR%		-58410	-79650	-26550	12390	=Salvage Value
=Pretax cash flows			-27410	-48650	4450
-taxes	=(Pretax cash flows)*(1-tax)		-17816.5	-31622.5	2892.5
+Depreciation			58410	79650	26550
=c. after tax operating cash flow			40593.50	48027.50	29442.5
reversal of working capital					8000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				53625
+Tax shield on salvage book value	=Salvage value * tax rate				4336.5
=Terminal year after tax cash flows					65961.5
Total Cash flow for the period		-185000	40593.5	48027.5	95404
Discount factor=	(1+discount rate)^corresponding period	1	1.13	1.2769	1.442897
Discounted CF=	Cashflow/discount factor	-185000	35923.451	37612.577	66119.758
NPV=	Sum of discounted CF=	-45344.21

D

Reject project as NPV is negative