Question

You must evaluate a proposal to buy a new milling machine. The base price is $188,000, and shipping and installation costs would add another $11,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $112,800. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $5,000 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 $31,000 per year. The marginal tax rate is 35%, and the WACC is 14%. 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? I. 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. II. 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. III. The cost of research is an incremental cash flow and should be included in the analysis. IV. Only the tax effect of the research expenses should be included in the analysis. V. 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. -Select- b. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year O 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? -Select- v

Answer 1

Qa) 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

Qb) Initial outlay = cost of machine + installation cost + working capital

= 188,000 + 11,000 + 5,000

= $204,000

Qc) Cash flows

Years	1	2	3
EBITDA	31,000	31,000	31,000
(-)Depreciation	(65,670)	(89,550)	(29,850)
EBT	(34,670)	(58,550)	1,150
(-) Taxes	12,134.5	20,492.5	(402.5)
Net income	(22,535.5)	(38,057.5)	747.5
(+)After tax salvage value	-	-	78,195.5
(+)working capital	-	-	5,000
(+) depreciation	65,670	89,550	29,850
Annual Cash flow	43,134.5	51,492.5	113,793

Notes:

Depreciation year 1 = 199,000 × 33% = 65,670

Year 2 = 199,000 × 45%= 89,550

Year 3 = 199,000 × 15%= 29,850

Value after depreciation = 199,000 - 65,670 - 89,550 - 29,850

= 13,930

After tax salvage value = selling price - [selling price - book value] (tax rate)

112,800 - [112,800 - 13,930] (0.35)

= 112,800 - (98,870 × 0.35)

= 112,800 - 34,604.5

= 78,195.5

Qd) Using financial calculator to find the NPV

Inputs: C0= -204,000

C1= 43,134.5 frequency= 1

C2= 51,492.5  Frequency= 1

C3= 113,793. Frequency= 1

I= 14%

Npv= compute

We get, Npv of the project as ($49,733.88)

As the Npv is negative, we should not purchase the machine.