Question

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112: End-of-Chapter Problems - Cash Flow Estimation and Risk Analysis Click here to read the eBook: Analysis of an Expansion Project Q Search this cours NEW PROJECT ANALYSIS You must evaluate a proposal to buy a new milling machine. The base price is $197,000, 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 $88,650. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $7,000 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 $55,000 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. a. How should the $5,000 spent last year be handled? I. 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. 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 as an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis. -Select- b. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year project cash flow Round your answer to the nearest cent. c. What are the project's annual cash flows during Years 1, 2, and 37 Round your answer to the nearest cent. Do not round your intermediate calculations. Year 1 $ Year 25 Year 3 $ d. Should the machine be purchased? Select

Answer 1

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Ans a)	Correct answer is option I: 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.
	Computation of depreciation =
	Total cost = 197000+7000		204000
	year	1	2	3
	Depreciation rate	33.00%	45.00%	15.00%
	Depreciation amt	67,320	91,800	30,600
	book value at year -3 end	14,280
	Computation of NPV
	year	0	1	2	3
a	initial investment	(204,000)
b	Working capital	(7,000)
A	Initial investment	(211,000)
	operating cash flow
i	Annual saving		55,000	55,000	55,000
ii	Depreciation rate		33.00%	45.00%	15.00%
iii	depreciation		67,320	91,800	30,600
iv=i-iii	Profit before tax		(12,320)	(36,800)	24,400
v=iv*35%	Tax@ 35%		(4,312)	(12,880)	8,540
vi=iv-v	Profit after tax		(8,008)	(23,920)	15,860
B=vi+iii	operating cash flow		59,312	67,880	46,460
	Terminal cash flow
i	Release of working capital =				7,000
ii	Post tax salvage value
	88650-(88650-14280)*35%				62621
C	NWC + salvage value				69621
D=A+B+C	Net cash flow	(211,000)	59,312	67,880	116,081
D	PVIF @ 14%	1.0000	0.8772	0.7695	0.6750
E=C*D	present value	(211,000)	52,028	52,231	78,351		(28,389)
	Therefore NPV =	(28,389)
ans b)	Year 0 Cash flow	(211,000)
Ans C)
	year -1	59,312
	year -2	67,880
	year -3	116,081
Ans d)	NO : Because NPV is negative
Ans d)	NPV =	(28,389)