Question

You must evaluate a proposal to buy a new milling machine. The base price is $108,000, and shipping and installation costs would add another $7,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $48,600. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $5,500 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 $59,000 per year. The marginal tax rate is 35%, and the WACC is 9%. 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? 1. Only the tax effect of the research expenses should be included in the analysis. II. 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. III. 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 IV. 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. V. The cost of research is an incremental cash flow and should be included in the analysis. Select-

Answer 1

iV.Sunk cost, Should not be included
a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital
=-108,000-7,000-5,500
(120,500)	since outflow
b.Annual Cash Flows:
	Year 1	2	3
Savings in Cost	59,000	59,000	59,000
Less: Depreciation	37,950	51,750	17,250
Net Savings	21,050	7,250	41,750
Less: Tax @35%	7,367.50	2,537.50	14,612.50
Income after Tax	13,682.50	4,712.50	27,137.50
Add: Depreciation	37,950	51,750	17,250
Operating Cash Flow	51,632.50	56,462.50	44,387.50
Add: After tax salvage value			34,407.50
Recovery of Working capital			5,500
Additional cash flows			39,908
Annual Cash flows	51,632.50	56,462.50	84,295.00
Written down value	8,050
Sale price	48600
Gain on sale	40,550
Tax	14192.5
After tax salvage value	34407.5
c.NPV = Present value of cash inflows – present value of cash outflows
= 51632.50*PVF(9%, 1 year) + 56462.50*PVF(9%, 2 years) + 84295*PVF(9%, 3 years) – 120500
39483.82913
Yes, should be purchased (since NPV is positive)