You must evaluate a proposal to buy a new machining station. The base price is $

Question

You must evaluate a proposal to buy a new machining station. The base price is $125,000, and shipping and installation costs would add another $15,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $70,000. The applicable deprecation rates are 33, 45, 15 and 7 percent . The machine would require a $5,000 increase in net operating working capital (increased inventory less increased accounts payable.) There would be no effect on costs (except for depreciation), but pre-tax revenues due to this machine would be $45,500 each year. There is no inflation. The marginal tax rate is 40 percent, and the required return on capital is 12 percent. Also, the firm spent $7,000 last year investigating the feasibility of using the machine. Note that the additional revenue each year due to the Project is $45,500 (there is no inflation). Also, the rest of the firm is profitable and pays income tax; furthermore, the company has paid more than $25,000 in taxes each year for the past two years. Hence, a tax loss carryback can be used if the firm has negative EBIT from the new machine; consequently, the firm can receive a refund of taxes paid in previous years.

A. How should the $7,000 spent last year be handled?

B. What is the net cost of the machine for capital budgeting purposes, that is, the Year 0 project cash flow?

C. What are the net operating cash flows during Years 1, 2, and 3?

D. What is the terminal year cash flow?

E. Should the machine be purchased? Explain your answer. What is the NPV of the machine?

Explanation / Answer

1 .Total outlfow for machine Base price 125000 installation cost 15000 total 140000 2. Life of machine= 3 years 3. Salvage value after 3 years is $70000 note: it can be presumed that end of 3 year 4. tax rates year 1 2 3 4 33 45 15 7 5. Increease in working capital is $5000 inflow is $45500 per year 6 marginal tax rate is 40 % , as cost of capital is pre tax therefore post tax rate shall be 12 (1-0.40) = 7.2% 7. firm paid earlier tax rates at $25000 extra , as not relevant 8   or ans 1 . $7000 has spent in last year is not relevant for evaluation as this is the cost spent in earlier year, it is a sunk cost, not relevant for decision calculation of depreciation year value tax rate dep tax saving @40% 1 140000 0.33 46200 18480 2 140000 0.45 63000 25200 3 140000 0.15 21000 8400 4 140000 0.07 9800 3920 1 computation of capital gain wriiten downvalue at end of 3 year 140000-46200-63000-21000 = 9800 salvage value at end 70000 capital gain 60200 less tax @40% 24080 net 36120 year 0 1 2 3 total outflow of machine -140000 inflow 45500 45500 45500 tax saving on dep 18840 25200 8400 salvage value 36120 working capital required -5000 -5000 -5000 net outflow (a) -140000 59340 65700 85020 present value factor 1 0.933 0.87 0.812 at 7.2% (b) present value(a*b) -140000 55364.22 57159 69036.24 41559.46 Net present value is present value of inflow - outflow , here NPV is positive , therefore project is acceptable

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