You must evaluate a proposal to buy a new milling machine. The purchase price of the milling machine, including shipping and installation costs, is $122,000, and the equipment will be fully depreciated at the time of purchase. The machine would be sold after 3 years for $47,000. The machine would require a $7,500 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 $30,000 per year. The marginal tax rate is 25%, and the WACC is 8%. Also, the firm spent $4,500 last year investigating the feasibility of using the machine.
Last year expense will be treated as sunk cost. This expense is already incurred and whether project is accepted or rejected, the amount already spent is not going to | |||||||
come back so this cost is treated as sunk cost. | |||||||
Tax rate | 25% | ||||||
Calculation of annual depreciation | |||||||
Depreciation | Year-1 | Year-2 | Year-3 | Total | |||
Cost | $ 122,000 | $ 122,000 | $ 122,000 | ||||
Dep Rate | 100.00% | 0.00% | 0.00% | ||||
Depreciation | Cost * Dep rate | $ 122,000 | $ - | $ - | $ 122,000 | ||
Calculation of after-tax salvage value | |||||||
Cost of machine | $ 122,000 | ||||||
Depreciation | $ 122,000 | ||||||
WDV | Cost less accumulated depreciation | $ - | |||||
Sale price | $ 47,000 | ||||||
Profit/(Loss) | Sale price less WDV | $ 47,000 | |||||
Tax | Profit/(Loss)*tax rate | $ 11,750 | |||||
Sale price after-tax | Sale price less tax | $ 35,250 | |||||
Calculation of annual operating cash flow | |||||||
Year-1 | Year-2 | Year-3 | |||||
Saving in labor cost | $ 30,000 | $ 30,000 | $ 30,000 | ||||
Less: Depreciation | $ 122,000 | $ - | $ - | ||||
Profit before tax (PBT) | $ (92,000) | $ 30,000 | $ 30,000 | ||||
Tax@25% | PBT*Tax rate | $ (23,000) | $ 7,500 | $ 7,500 | |||
Profit After Tax (PAT) | PBT - Tax | $ (69,000) | $ 22,500 | $ 22,500 | |||
Add Depreciation | PAT + Dep | $ 122,000 | $ - | $ - | |||
Cash Profit after-tax | $ 53,000 | $ 22,500 | $ 22,500 | ||||
Calculation of NPV | |||||||
8.00% | |||||||
Year | Capital | Working capital | Operating cash | Annual Cash flow | PV factor, 1/(1+r)^time | Present values | |
0 | $ (122,000) | $ (7,500) | $ (129,500) | 1.0000 | $ (129,500) | ||
1 | $ 53,000 | $ 53,000 | 0.9259 | $ 49,074 | |||
2 | $ 22,500 | $ 22,500 | 0.8573 | $ 19,290 | |||
3 | $ 35,250 | $ 7,500 | $ 22,500 | $ 65,250 | 0.7938 | $ 51,798 | |
Net Present Value | $ (9,338) | ||||||
Since NPV is negative, the machine should not be purchased. |
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