You must evaluate a proposal to buy a new milling machine. The base price is $12
ID: 2777048 • Letter: Y
Question
You must evaluate a proposal to buy a new milling machine. The base price is $123,000, and shipping and installation costs would add another $17,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $49,200. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $6,000 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 $57,000 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.
a) How should the $5,000 spent last year be handled?
I. 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.
II. The cost of research is an incremental cash flow and should be included in the analysis.
III. Only the tax effect of the research expenses should be included in the analysis.
IV. 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.
V. 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.
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 ___
Explanation / Answer
Cost of asset123,000
Installation cost17,000
Net working capital 6,000
Total initial cash outlay146,000
Year
1
2
3
Depreciation basis
123000
123000
123000
xMACRS rate
33%
45%
15%
"=Depreciation "
40590
55350
18450
x tax rate
35%
35%
35%
"=Depreciation tax shield
14206.5
19372.5
6457.5
Net Cash income= save in costs x( 1- tax rate)
= 57,000 x (1 -0.35)
= 37,050
Book value at the end of year 3 = cost of asset x last year MACRS rate
= 123,000 x 7%
= 8610
Net salvage value =salvage value –( salvage value – book value)x tax rate
= 49,200 – ( 49200-8610) x35%
= 34,993.50
Year 1 Cash flow
Cash flow = Net Cash income + Depreciation tax shield
= 37,050 +
= 51,256.50
Year 2 Cash flow
Cash flow = Net Cash income + Depreciation tax shield
= 37,050 +
= 56,422.50
Year 3 Cash flow
Cash flow = Net Cash income + Depreciation tax shield+ net salvage value + working cap recovered
= 37,050 +
= 84,501
Year
1
2
3
Depreciation basis
123000
123000
123000
xMACRS rate
33%
45%
15%
"=Depreciation "
40590
55350
18450
x tax rate
35%
35%
35%
"=Depreciation tax shield
14206.5
19372.5
6457.5
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