Question

Please explain to me the answers so that I can understand the concept. Thank you!

You must evaluate a proposal to buy a new milling machine. The purchase price of the milling machine, including shipping and installation costs, is $126,000, and the equipment will be fully depreciated at the time of purchase. The machine would be sold after 3 years for $85,000. The machine would require a $3,500 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 $46,000 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. Last year's expenditure should be treated as 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 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 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.
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?

Answer 1

(a) The correct answer is III. ie. 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.

(b)

Cost of machine	126,000
Less: Tax saved on depreciation [126,000 x 25%]	(31,500)
Add: Increase in working capital requirement	3,500
Total outflow	98,000

(c)

	Year 1	Year 2	Year 3
Saved in labor costs	46,000	46,000	46,000
Less: Tax @25%	(11,500)	(11,500)	(11,500)
Net saving	34,500	34,500	34,500
Add: Working capital release			3,500
Add: Salvage value after tax [85,000 x (1 - 0.25)]			63,750
Total cash inflow	34,500	34,500	101,750

(d)

	Year	Amount	PV@12%	Discounted value
Initial investment	0	(98,000)	1	(98,000)
Cash inflow	1	34,500	0.893	30,809
Cash inflow	2	34,500	0.797	27,497
Cash inflow	3	101,750	0.712	72,446
			NPV	32,752

As the NPV is positive, it should be accepted