Question

You must evaluate a proposal to buy a new milling machine. The base price is $191,000, 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 $95,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $6,000 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 $40,000 per year. The marginal tax rate is 35%, and the WACC is 10%. 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 is considered as a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
2. The cost of research is an incremental cash flow and should be included in the analysis.
3. Only the tax effect of the research expenses should be included in the analysis.
4. 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.
5. 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

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

a.I.Sunk cost and does not represent incremental cash flow and should not be included

a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital

= -191,000-18,000-6,000

= -$215,000

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	40,000	40,000	40,000
Less: Depreciation	68,970	94,050	31,350
Net Savings	-28,970	-54,050	8,650
Less: Tax @35%	-10,139.5	-18,917.5	3,027.5
Income after Tax	-18,830.5	-35,132.5	5,622.5
Add: Depreciation	68,970	94,050	31,350
Cash Flow	50,139.5	58,917.5	36,972.5
Add: After tax salvage value			67,195.5
Recovery of Working capital			6,000
Cash Flow	50,139.5	58,917.5	110,168

Note: Written down value of machine = 209,000*7% = $14,630

Sale Price = $95,500

Gain on Sale = $80,870

Tax on Gain = $28,304.5

After tax salvage value = 95,500 – 28,304.5 = $67,195.5

c.NPV = Present value of cash inflows – present value of cash outflows

= 50,139.5*PVF(10%, 1 year) + 58,917.5*PVF(10%, 2 years) + 110,168*PVF(10%, 3 years) – 215,000

= 50,139.5*0.909 + 58,917.5*0.826 + 110,168*0.751 – 215,000

= -$38,021.17

No, should not be purchased (since NPV is negative)