Company ABC needs to install a new manufacturing machine. The base price is $100

Question

Company ABC needs to install a new manufacturing machine. The base price is $100,000. Installation costs are $10,000. After 3 years the machine will be sold for $75,000. Applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent. The machine would require a $5,000 increase in net operating working capital (increased inventory less increased accounts payables). Revenue would not be affected. Pretax labor costs would decline by $40,000 per year. The marginal tax rate is 40 percent, and the WACC is 10 percent. Also, the firm spent $7,000 in feasibility tests. 1) $7,000 was spent last year. How should this be handled? 2) For capital budgeting purposes, what is the intial investment outlay for the machine? What is the Year 0 project cash flow? Please show calculations.

Explanation / Answer

1)   $7,000 that was spent last yr in feasibility tests is a sunk cost . Hence this cost is irrelevant for capital budgeting decisions

2) intial investment outlay for the machine=$100,000 + $10,000 = $110,000

3) Cash flow at year 0 : $110,000 + working capital reqd

$110,000 +$5,000

$115,000

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