New project analysis You must evaluate a proposal to buy a new milling machine.
ID: 2762557 • Letter: N
Question
New project analysis
You must evaluate a proposal to buy a new milling machine. The base price is $180,000, 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 $72,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $6,000 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 $60,000 per year. The marginal tax rate is 35%, and the WACC is 12%. 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?
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.
Only the tax effect of the research expenses 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?
-Select-yesno Yes or No?
Explanation / Answer
How should the $5,000 spent last year be handled? 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. This is because such expenditure has been incurred and it won’t reverse whether new machine is bought or not Initial Outlay Calculation Base Price of Machine (a) $180,000 Shipping and Installation Cost (b) $10,000 Cost of Machine (c = a+b) $190,000 Working Capital Requirement (d) $6,000 Total Initial Outlay (c+d) $196,000 Annual Cash Inflow Calculation Year 1 2 3 Savings in Labor Cost (a) $60,000.00 $60,000.00 $60,000.00 Post tax Savings in Labor Cost (b = a*0.65) $39,000.00 $39,000.00 $39,000.00 Depreciation Rate ( c) 33% 45% 15% Depreciation (d = $190000* c) $62,700.00 $85,500.00 $28,500.00 Depreciation Tax Shield (e = d * 35%) $21,945.00 $29,925.00 $9,975.00 Net Increase in Cashflows (f = b+e) $60,945.00 $68,925.00 $48,975.00 Realization of Working Capital (g) $0.00 $0.00 $6,000.00 Post tax salvage value of machine (h) - Note 1 $0.00 $0.00 $51,455.00 Project Annual Cashflows (i = f+g+h) $60,945.00 $68,925.00 $106,430.00 PV Factor at WACC - 12% (j) 0.89286 0.79719 0.71178 Present Value at 12% (i*j) $54,415.18 $54,946.59 $75,754.77 Present Value of Inflows = $185,116.54 Initial Outlay = $196,000 NPV = -$10,883.46 Machine should not be purchased as the Net present value of project is negative Note 1 Book Value of Machine ($190000 - Accum Dep) (A) $13,300.00 Sale value of machine (B) $72,000.00 Profit From sale of machinery (C = B -A) $58,700.00 Tax on Profit at 35% (D = C*0.35) $20,545.00 Post tax salvage value (B - D) $51,455.00