Question

You must evaluate a proposal to buy a new milling machine. The base price is $100,000, and shipping and installation costs would add another $6,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $40,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. 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 $60,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $4,500 last year investigating the feasibility of using the machine.

a. How should the $4,500 spent last year be handled?

b. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest cent.

c. 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 cent.

d. Should the machine be purchased?

Answer 1

Amount spent last year is a sunk cost already incurred and hence not relevant
a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital
=100,000+6,000+4000
110,000	since outflow
b.Annual Cash Flows:
	Year 1	2	3
Savings in Cost	60,000	60,000	60,000
Less: Depreciation	34,980	47,700	15,900
Net Savings	25,020	12,300	44,100
Less: Tax @35%	8,757.00	4,305.00	15,435.00
Income after Tax	16,263.00	7,995.00	28,665.00
Add: Depreciation	34,980	47,700	15,900
Operating Cash Flow	51,243.00	55,695.00	44,565.00
Add: After tax salvage value			28,597.00
Recovery of Working capital			4,000
Additional cash flows			32,597
Annual Cash Flow	51,243.00	55,695.00	77,162.00
Written down value	7,420
Sale price	40000
Gain on sale	32,580
Tax	11403
After tax salvage value	28597
c.NPV = Present value of cash inflows – present value of cash outflows
= 51243*PVF(10%, 1 year) + 55695*PVF(10%, 2 years) + 77162*PVF(10%, 3 years) – 110000
40586.42374
Yes, should be purchased (since NPV is positive)