Question

You must evaluate a proposal to buy a new milling machine. The base price is $154,000, and shipping and installation costs would add another $20,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $92,400. 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 $52,000 per year. The marginal tax rate is 35%, and the WACC is 11%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

1. How should the $5,000 spent last year be handled?
   1. Only the tax effect of the research expenses should be included in the analysis.
   2. 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.
   3. 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.
   4. 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.
   5. The cost of research is an incremental cash flow and should be included in the analysis.

2. 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.
   $

3. 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 $

4. Should the machine be purchased?
   Y/N

Answer 1

1-
cost of equipment		-154000
Addition to equipment		-20000
investment in working capital		-5000
total cash outflow		-179000
2-
year	value to be depreciated of machine (cost of machine+addition)	MACRS rate	annual depreciation = (cost of machine+addition )*MACRS rate
1	174000	33%	57420
2	174000	45%	78300
3	174000	15%	26100
total depreciation accumulated			161820
book value of equipment at the end of year 3	174000-161820		12180
gain on sale of equipment	92400-12180		80220
tax on gain = 35%	80220*35%		28077
after tax net sale proceeds	92400-28077		64323
year		1	2	3
annual savings in labor cost		52000	52000	52000
less annual depreciation		57420	78300	26100
operating savings		-5420	-26300	25900
after tax savings = operating savings*(1-tax rate)		-3523	-17095	16835
add annual depreciation		57420	78300	26100
recovery of working capital				5000
after tax net sale proceeds				64323
net operating cash flow		53897	61205	112258
3-
year	0	1	2	3
total cash outflow	-179000
net operating cash flow		53897	61205	112258
present value factor at 11%	1	0.900900901	0.81162243	0.731191381
present value of cash flow = net operating cash flow*present value factor	-179000	48555.85586	49675.351	82082.08208
NPV = sum of present value of cash flow	1313.3
Yesequipment should not be purchased as it results in positive NPV
A-	Option is 4	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