Problem 12-9 New project analysis You must evaluate a proposal to buy a new mill
ID: 2754819 • Letter: P
Question
Problem 12-9
New project analysis
You must evaluate a proposal to buy a new milling machine. The base price is $175,000, and shipping and installation costs would add another $10,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $113,750. 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 $50,000 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.
How should the $5,000 spent last year be handled?
Only the tax effect of the research expenses should be included in the analysis.
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.
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.
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.
The cost of research is an incremental cash flow and should be included in the analysis.
-Select-IIIIIIIVVItem 1
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.
$
What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Year 1 $
Year 2 $
Year 3 $
Should the machine be purchased?
Explanation / Answer
How should the $5,000 spent last year be handled?
Answer: 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.The $5,000 is a sunk cost and therefore is not relevant to the analysis.
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.
Answer: Net Cost of the machine = $175,000 + $10,000 + $4,000
= $189,000
What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Answer:
Should the machine be purchased?
Answer: No, the machine should not be purchased as the investment has a negative NPV of $1425 as per the following table.
NPV:
Year Dep rate Depreciation ($) Tax saving on dep 1 33% 61050 21367.5 2 45% 83250 29137.5 3 15% 27750 9712.5 4 7% 12950 4532.5 Year Particulars 0 1 2 3 After tax saving 32500 32500 32500 Tax saving on dep 21368 29138 9713 Net cash flow 53868 61638 42213