7. New project analysis You must evaluate a proposal to buy a new milling machin

Question

7. New project analysis

You must evaluate a proposal to buy a new milling machine. The base price is $155,000, and shipping and installation costs would add another $18,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $77,500. 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 $59,000 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?

Answer: Last year's expenditure is considered as 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. Do not round your intermediate calculations.
Year 1 $___________      
Year 2 $___________      
Year 3 $___________      

Explanation / Answer

1. How should the $5,000 spent last year be handled?

Solution-

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 $5,000 is a sunk cost and therefore is not relevant to the analysis)

2. 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.

Solution-

Initial investment outlay for the machine=$155,000+$18,000+$10,000

Initial investment outlay for the machine=$183,000

3. What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.

Solution-

Year

Year

Year

1

2

3

After-Tax Savings

$38350

$38350

$38350

Depreciation Tax Savings

$19981.50

$27247.50

$9082.50

Net Cash Flow

$58331.50

$65597.50

$47432.50

Note:
1. The after-tax cost savings is $59,000(1 - T) = $59,000(0.65) = $38,350

2. The depreciation expense in each year is the depreciable basis, $173,000, times the MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation expense in Years 1, 2, and 3 is $41,910, $57,150, and $19,050. The depreciation tax savings is calculated as the tax rate (35%) times the depreciation expense in each year.

Year

Year

Year

1

2

3

After-Tax Savings

$38350

$38350

$38350

Depreciation Tax Savings

$19981.50

$27247.50

$9082.50

Net Cash Flow

$58331.50

$65597.50

$47432.50

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