Problem 12-9 New project analysis You must evaluate a proposal to buy a new mill
ID: 2764432 • Letter: P
Question
Problem 12-9
New project analysis
You must evaluate a proposal to buy a new milling machine. The base price is $164,000, and shipping and installation costs would add another $7,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $82,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $7,500 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 $41,000 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?
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.
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.
-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
Explanation / Answer
1)
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.
Machine should not be purchased as NPV is negative
Time line 0 1 2 3 Cost of equipment 164000 Installation cost 7000 Total investment in new machine 171000 Increase in working capital 7500 0 0 0 =Initial Investment outlay -178500 Labor cost savings= 41000 41000 41000 MACR rate 33% 45% 15.00% 7.00% -Depreciation MACR Rate* total investment -56430 -76950 -25650 -11970 salvage book value = -15430 -35950 15350 -taxes =(Profit- depreciation)*(1-tax) -10029.5 -23367.5 9977.5 +Depreciation 56430 76950 25650 =after tax operating cash flow 46400.5 53582.5 35627.5 Reversal of W/C 7500 Proceeds from sale of assets =salvage value*(1 - tax rate) 53300 +Salvage book value * tax rate 4189.5 Terminal year non operating cash flows 64989.5 Total Cash flow for the period -178500 46400.5 53582.5 100617 Discount factor =(1+discount rate)^n 1 1.11 1.2321 1.367631 Discount rate= 11% Discounted cash flows -178500 41802.25 43488.76 73570.28 NPV= Sum of discounted cash flows -19638.7