Question

You must evaluate a proposal to buy a new milling machine. The base price is $177,000, and shipping and installation costs would add another $9,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $61,950. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $9,500 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 $50,000 per year. The marginal tax rate is 35%, and the WACC is 14%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

1. How should the $5,000 spent last year be handled?
   1. 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.
   2. The cost of research is an incremental cash flow and should be included in the analysis.
   3. Only the tax effect of the research expenses should be included in the analysis.
   4. 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.
   5. Last year's expenditure is considered as an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
   
   -Select-IIIIIIIVVItem 1

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.
   $

3. 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 $

4. Should the machine be purchased?
   -Select-YesNoItem 6

Answer 1

a.I. a sunk cost, no incremental cash flow, should not be included

b.Initial investment outlay = Cost of machine + installation cost + investment in working capital

= 177,000 + 9,000 + 9,500

= $195,500

c.

	Year 1	2	3
Savings in Labor cost	50,000	50,000	50,000
LesS: Depreciation	61,380	83,700	27,900
Net income before tax	-11,380	-33,700	22,100
Less: tax	-3,983	-11,795	7,735
Income after tax	-7,397	-21,905	14,365
Add: Depreciation	61,380	83,700	27,900
Cash Flow	53,983	61,795	42,265
Working capital released			9,500
After tax salvage value			44,824.5
Cash flow	53,983	61,795	96,589.5

d. NPV = 53,893/(1.14) + 61,795/(1.14)² + 96,589.5/(1.14)³_– 195,500

= -$35,481.03

Since NPV is negative, machine SHOULD NOT be purchased