Question

NEW PROJECT ANALYSIS You must evaluate a proposal to buy a new milling machine. The base price is $197,000, and shipping and installation costs would add another $9,000. The machine falls into the MACRS 3-year class, and would be sold after 3 years for $118,200. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $4,000 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 $34,000 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? should not be included in the analysis. I. Last year's expenditure is considered as a sunk cost and does not represent an incremental cash flow. Hence, incremental cash flow and should be included in the analysis II. The cost of research the analysis III. Only the tax effect of the research expenses should be included should not be included in the initial investment IV. Last year's expenditure should be treated as a terminal cash flow and dealt with at the end outlay. the project's life. Hence, V. 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. -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? 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 S Year 2 S Year 3 S d. Should the machine be purchased? -Select

Please show me the whole numbers also before rounding them so I can see thank you!

Answer 1

a.I.Sunk cost and does not represent incremental cash flow and should not be included

b.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital

= 197,000+9,000+4,000

= $210,000

b.Annual Cash Flows:

	Year 1	2	3
Savings in Cost	34,000	34,000	34,000
Less: Depreciation	67,980	92,700	30,900
Net Savings	-33,980	-58,700	3,100
Less: Tax @35%	-11,893	-20,545	1,085
Income after Tax	-22,087	-38,155	2,015
Add: Depreciation	67,980	92,700	30,900
Cash Flow	45,893	54,545	32,915
Add: After tax salvage value			81,877
Recovery of Working capital			4,000
Cash Flow	45,893	54,545	118,792

Note: Written down value of machine = 206,000*7% = $14,420

Sale Price = $118,200

Gain on Sale = $103,780

Tax on Gain = $36,323

After tax salvage value = 118,200 – 36,323 = $81,877

d.NPV = Present value of cash inflows – present value of cash outflows

= 45,893*PVF(14%, 1 year) + 54,545*PVF(14%, 2 years) + 118,792*PVF(14%, 3 years) – 210,000

= 45,893*0.877 + 54,545*0.769 + 118,792*0.675 - 210,000

= -$47,622.134

No, should not be purchased (since NPV is negative)