Question

You must evaluate a proposal to buy a new milling machine. The base price is $143,000, and shipping and installation costs would add another $7,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $50,050. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $9,000 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 $35,000 per year. The marginal tax rate is 35%, and the WACC is 12%. 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?
- 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.
- 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 as an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

-Select-IIIIIIIVVItem 1 -
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 $

- Should the machine be purchased?

Answer #1

Milling | 0 | 1 | 2 | 3 | |

MACRS % | 33% | 45% | 15% | 7% | |

Investment | -150,000 | 10,500 | |||

Salvage | 50,050 | ||||

NWC | -9,000 | 9,000 | |||

Savings | 35,000 | 35,000 | 35,000 | ||

Depreciation | -49,500 | -67,500 | -22,500 | ||

EBT | -14,500 | -32,500 | 12,500 | ||

Tax (35%) | 5,075 | 11,375 | -4,375 | ||

Profits | -9,425 | -21,125 | 8,125 | ||

Cash Flows | -159,000.00 | 40,075.00 | 46,375.00 | 75,832.50 | |

IRR | 0.93% |

I is correct. It is a sunk cost and should not be considered in analysis.

Depreciation = MACRS % x Investment

Cash Flows = Investment + NWC + After-tax Salvage Value + Profits + Depreciation

IRR can be calculated using the same function on a calculator or excel.

As IRR < WACC, the machine should not be purchased.

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