Question

You must evaluate a proposal to buy a new milling machine. The base price is $122,000, and shipping and installation costs would add another $18,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $79,300. 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 $34,000 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.

a. How should the $5,000 spent last year be handled?

1. 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.

2. 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.

3. 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.

4. The cost of research is an incremental cash flow and should be included in the analysis.

5. Only the tax effect of the research expenses should be included in the analysis.

b. 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.
$

c. 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 $

d. Should the machine be purchased?

Answer 1

Answer 3
A sunk cost is a cost that an entity has incurred, and which it can no longer recover by any means. Sunk costs should not be considered when making the decision to continue investing in an ongoing project
What is the initial investment outlay for the machine for capital budgeting purposes,
Question B
Cash outlay for new machine
base Price	$122,000
Modification	$18,000
Increase in Net WC	$8,000
	$148,000

	cost of new machine		$140,000
Question C
New machine
WN.3	depreciate the equipment with a 3-year MACRS
Year	0	1	2	3	4
depricarion %		33.00%	45.00%	15.00%	7.00%
CAPEX or cost of new machine	$140,000
deperication exp		46200	63000	21000	9800
Book value		$93,800	30,800.00	9,800.00	0.00
tax savings on deperication expense (46200*35%)		16170	22050	7350
book value at end of 3rd year	$9,800
salvage value of new machine	$79,300
profit or gain	$69,500
tax @35%	$24,325.00
Total after tax proceeds salvage value	$54,975.00	(WN;4)

WN;2
The after-tax cost savings is $34,000(1 – T) = $34,000(0.65) = $22100
Particular	Year 0	Year 1	Year 2	Year 3
Cash Outflow
Initital Investment	($148,000)
after tax savings in labout cost (WN2)		22100.00	22100.00	22100.00
ADD:tax savings on deperication (WN;3)		16170	22050	7350
Net cash flows		38270.00	44150.00	29450.00
Recovery of net WC				8000.00
Add :Salvage value ( WN 4)				$54,975.00
Annual Net Cash Flow	-148,000.00	38270.00	44150.00	92425.00

year	CF	PV CF @11%
0	-148,000.00	-148000.00
1	38270.00	34477.47748
2	44150.00	35833.13043
3	92425.00	67580.36342
	NPV	-10109.0287
Npv is negitive hence machine should not purchased.