Question

You must evaluate a proposal to buy a new milling machine. The purchase price of the milling machine, including shipping and installation costs, is $200,000, and the equipment will be fully depreciated at the time of purchase. The machine would be sold after 3 years for $86,000. The machine would require a $4,000 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 $54,000 per year. The marginal tax rate is 25%, and the WACC is 12%. Also, the firm spent $4,500 last year investigating the feasibility of using the machine.

1. How should the $4,500 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 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 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 after the 100% bonus depreciation is considered, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest dollar.
   $ _______
   
3. What are the project's annual cash flows during Years 1, 2, and 3? Do not round intermediate calculations. Round your answers to the nearest dollar.
   Year 1: $ ______
   Year 2: $ ______
   Year 3: $ ______
   
4. Should the machine be purchased?
   YES/NO

Answer 1

a

Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

Time line		0	1	2	3
Cost of new machine		-200000
Initial working capital		-4000
=b. Initial Investment outlay		-204000
						100.00%
Savings			54000	54000	54000
-Depreciation	Cost of equipment/no. of years		-66666.6667	-66666.6667	-66666.6667	0	=Salvage Value
=Pretax cash flows			-12666.6667	-12666.6667	-12666.6667
-taxes	=(Pretax cash flows)*(1-tax)		-9500	-9500	-9500
+Depreciation			66666.66667	66666.66667	66666.66667
=c. after tax operating cash flow			57167	57167	57167
reversal of working capital					4000
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				64500
+Tax shield on salvage book value	=Salvage value * tax rate				0
=Terminal year after tax cash flows					68500
Total Cash flow for the period		-204000	57166.67	57166.67	125666.67
Discount factor=	(1+discount rate)^corresponding period	1	1.12	1.2544	1.404928
Discounted CF=	Cashflow/discount factor	-204000	51041.66964	45572.91932	89447.05351
d. NPV=	Sum of discounted CF=	-17938.36

Reject as NPV is negative