Problem 12-9 New project analysis You must evaluate a proposal to buy a new mill
ID: 2777040 • Letter: P
Question
Problem 12-9
New project analysis
You must evaluate a proposal to buy a new milling machine. The base price is $142,000, 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 $56,800. 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 $30,000 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.
a. How should the $5,000 spent last year be handled?
I. 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.
II. 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.
III. The cost of research is an incremental cash flow and should be included in the analysis.
IV. Only the tax effect of the research expenses should be included in the analysis.
V. 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.
-Select-IIIIIIIVVItem 1
b. 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.
$
c. 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 $
d. Should the machine be purchased?
-Select-yesnoItem 6
Explanation / Answer
a. How should the $5,000 spent last year be handled?
II. 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.
b. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow?
Year 0 project cash flow = - Purchase cost of machine - shipping and installation costs - increase in net operating working capital
Year 0 project cash flow = -142000 - 20000 - 10000
Year 0 project cash flow = - 172000
c. What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent
Year 1 cash flow = pretax labor costs would decline*(1-tax rate) + Depreciation*tax rate
Year 1 cash flow = 30000*(1-35%) + (142000+20000)*33%*35%
Year 1 cash flow = $ 38211
Year 2 cash flow = pretax labor costs would decline*(1-tax rate) + Depreciation*tax rate
Year 2 cash flow = 30000*(1-35%) + (142000+20000)*45%*35%
Year 2 cash flow = $ 45015
Post Tax salvage Value = Sale value - tax rate*(sale value - book value)
Post Tax salvage Value = 56800 - 35%*(56800 - (162000*7%))
Post Tax salvage Value = 40889
Terminal Cash Flow = Post Tax salvage Value + Working Capital Recovered
Terminal Cash Flow = 40889 + 10000
Terminal Cash Flow = 50889
Year 3 cash flow = pretax labor costs would decline*(1-tax rate) + Depreciation*tax rate + Terminal Cash Flow
Year 3 cash flow = 30000*(1-35%) + (142000+20000)*14%*35% + 50889
Year 3 cash flow = $ 78,327
d. Should the machine be purchased?
NPV = - initial investment + Year 1cash flow /1.12 + Year 2cash flow /1.12^2 + Year3cash flow /1.12^3
NPV = - 172000 + 38211/1.12 + 45015/1.12^2 + 78327/1.12^3
NPV = - 46,24574
Decision : NO, Since NPV is negative the project is not viable