You must evaluate a proposal to buy a new milling machine. The base price is $10
ID: 2577876 • Letter: Y
Question
You must evaluate a proposal to buy a new milling machine. The base price is $105,000, 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 $42,000. 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 $43,000 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? (pick one)
-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.
-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.
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 or no)
Explanation / Answer
1. $5,000 spent last year is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
2. Initial Investment in machine at year 0 = $105,000 + $10,000 = $115,000
3. Calculation of annual project cash flows.
Particulars
Amount (In $)
(A)
Present Value Time
Time 1 (PV = 0.9009)
Time 2(PV = 0.8116)
Time 3 (PV = 0.7312)
Savings on labor cost (Net of Tax)
43,000 (1-0.35) = 27,950
25,180.15
22,684.22
20,437.04
Tax Savings on Depreciation
115,000 x 33% x 35% = 13,282.5
11,966.20
Tax Savings on Depreciation
115,000 x 45% x 35% = 18,112.5
14,700
Tax Savings on Depreciation
115,000 x 15% x 35% = 6,037.5
4,414.62
Increase in net operating working capital
7,500
(6,756.75)
(6,087)
(5,484)
Sale of machine net of tax
30,117.5
22,022
Net Cash Flows
30,390
31,300
41,400
NOTE: Calculation of gain on sale of machine
Book Value at end of 3year = 115,000 x 7% = 8,050
Gain on sale = $42,000 – 8,050 = $33,950
Tax on gain = 33,950 x 35% = 11,882.5
Net cash inflows from sale of machine = $42,000 – 11,882.5 = $30,117.5
4. Since the Total present value of cash flows amounting to $103,090 is less than the initial investment amount of $115,000. The machine should not be purchased.
Particulars
Amount (In $)
(A)
Present Value Time
Time 1 (PV = 0.9009)
Time 2(PV = 0.8116)
Time 3 (PV = 0.7312)
Savings on labor cost (Net of Tax)
43,000 (1-0.35) = 27,950
25,180.15
22,684.22
20,437.04
Tax Savings on Depreciation
115,000 x 33% x 35% = 13,282.5
11,966.20
Tax Savings on Depreciation
115,000 x 45% x 35% = 18,112.5
14,700
Tax Savings on Depreciation
115,000 x 15% x 35% = 6,037.5
4,414.62
Increase in net operating working capital
7,500
(6,756.75)
(6,087)
(5,484)
Sale of machine net of tax
30,117.5
22,022
Net Cash Flows
30,390
31,300
41,400
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