Question

You must evaluate a proposal to buy a new milling machine. The base price is $107,000, 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 $37,450. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $3,500 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 $56,000 per year. The marginal tax rate is 35%, and the WACC is 11%. 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. The cost of research is an incremental cash flow and should be included in the analysis. II. Only the tax effect of the research expenses should be included in the analysis. III. 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. IV. 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. V. 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. -Select- 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, $

Answer 1

Answer (a)

Option V = 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

Answer (b)

Initial Investment Outlay = Basic Price + Installation Cost

= $ 107,000 + $ 11,000

= $ 118,000

Answer (c)

Caclulation of Incremental Cash Flows

Particulars Year 1 2 3 Saving in Labour Cost $   56,000.00 $   56,000.00 $   56,000.00 Profit on Sale of Machine (Sale Value - WDV at 3 Years) $                   -   $                   -   $   29,190.00 Depreciation $ (38,940.00) $ (53,100.00) $ (17,700.00) Gross Saving $   17,060.00 $      2,900.00 $   67,490.00 Less: Tax @ 35% $      5,971.00 $      1,015.00 $   23,622.00 Net Saving $   11,089.00 $      1,885.00 $   43,868.00 Add: Depreciation $   38,940.00 $   53,100.00 $   17,700.00 Less: Profit on Sale of Machine (Sale Value - WDV at 3 Years) $                   -   $                   -   $   29,190.00 Add: Sale Value of Machine $                   -   $                   -   $   37,450.00 Less: Working Capital Requirement $      3,500.00 $                   -   $   (3,500.00) Incremental Cash Flows $   46,529.00 $   54,985.00 $   73,328.00

Year 1 = $ 46,529.00

Year 2 = $ 54,985.00

Year 3 = $ 73,328.00

Solution (d)

Calculation of NPV

Year	Incremental Cash Flow	Present Value Factor @ 11%	Present Value
1	$    46,529.00	0.901	$      41,922.63
2	$    54,985.00	0.812	$      44,647.82
3	$    73,328.00	0.731	$      53,602.77
Present Value of Future Cash Inflows			$    140,173.22
Less: Initial Investment			$    118,000.00
NPV			$      22,173.22

Since NPV is Positive, Machine Should be Purchase