New project analysis You must evaluate a proposal to buy a new milling machine.
ID: 2764507 • Letter: N
Question
New project analysis You must evaluate a proposal to buy a new milling machine. The base price is $195,000, and shipping and installation costs would add another $20,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $97,500. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $10,000 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 $40,000 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.
How should the $5,000 spent last year be handled?
a. The cost of research is an incremental cash flow and should be included in the analysis.
b. Only the tax effect of the research expenses should be included in the analysis.
c. 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.
d. 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.
e. 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.
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? YES/NO
Explanation / Answer
How 5,000 should be handled:
Answer e:
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.
Cash flow in year 0 = Purcase + shipping increase in Working capital = 195,000 + 20,000 + 10000 = - 225,000 (negative since it is an outflow)
The deatils are as shown below:
Cash flow in year 1 = $40,000
Cash flow in year 2 = $40,000
Cash flow in year 3 = $114,390
The machine should NOT be purchase (NO) - Since NPV is negative
Year 0 1 2 3 Initial Investment -195000 Installation costs -20000 increase in net working capital -10000 Cost Savings 40000 40000 40000 Depreciation 64350 87750 29250 Profit before tax -24350 -47750 10750 taxes at 35% 0 0 3762.5 Profit after tax -24350 -47750 6987.5 Add back depreciation 64350 87750 29250 Return of Working Capital 10000 Salavage value of the machine after tax 68152.5 Net Cash flow -225000 40000 40000 114390 NPV $ -69,635.61 Salavge Value calculation Book Value 13650 Sale Value 97500 Taxable amount 83850 Tax at 35% 29347.5 Salavge value after tax 68152.5