New project analysis You must evaluate a proposal to buy a new milling machine.
ID: 2699855 • Letter: N
Question
New project analysis
You must evaluate a proposal to buy a new milling machine. The base price is $148,000, and shipping and installation costs would add another $17,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $66,600. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $4,500 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 $42,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.
Explanation / Answer
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 $12,500. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The applicable depreciation rates are 33, 45, 15 and 7 percent as discussed in Appendix 12A of your text book. The machine would require a $5,500 increase in working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pre-tax labor costs would decline by $44,000 per year. The marginal tax rate is 35 percent, and the WACC is 12 percent. 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?
The $5,000 is a sunk cost and therefore is not relevant to the analysis
b) What is the net cost of the machine for capital budgeting purposes, that is, the Year 0 project cash flow?
Net Cost of the machine = $108,000 + $12,500 + $5,500
= $126,000
c) What are the net operating cash flows during Years 1, 2 and 3?
Year
0
1
2
3
After-Tax Savings
$28,600
$28,600
$28,600
Depreciation Tax Savings
$13,918
$18,979
$6,326
Net Cash Flow
$42,518
$47,579
$34,926
d) What is the terminal year cash flow?
Salvage Value
$65,000
Tax on Salvage Value
$19,798
NWC Recovery
$5,500
Terminal Cash Flow
$50,702
e) Should the machine be purchased? Explain your answer.
Yes, the machine should be purchased as the investment has a positive NPV of $10,840 as per the following table.
NPV Analysis
Year
Cash Flow
PV Factor @ 12%
PV
0
($126,000)
1
($126,000)
1
$42,518
0.8929
$37,962
2
$47,579
0.7972
$37,929
3
$85,629
0.7118
$60,949
NPV
$10,840
Year
0
1
2
3
After-Tax Savings
$28,600
$28,600
$28,600
Depreciation Tax Savings
$13,918
$18,979
$6,326
Net Cash Flow
$42,518
$47,579
$34,926