Question

9. Problem 12.09 (New Project Analysis) eBook You must evaluate a proposal to buy a new milling machine. The base price is $104,000, and shipping and installation costs would add another $8,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $36,400. The applicable depreciation rates are 33 %, 45 % , 15 %, and 7 %. The machine would require a $4,500 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 $60,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $4,500 last year investigating the feasibility of using the machine. a. How should the $4,500 spent last year be handled? I. 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 II. 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 III. The cost of research is an incremental cash flow and should be included in the analysis. IV. Only the tax effect of the research expenses should be included in the analysis. V. 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 -Select b. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest cent. c. What are the project's annual cash flows during Years 1, 2, and 3? Do not round intermediate calculations. Round your answers to the nearest cent Year 1: $ Year 2: $ Year 3: $ d. Should the machine be purchased? -Select

Answer 1

a

V. 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

Time line		0	1	2	3
Cost of new machine		-104000
Initial working capital		-4500
=b. Initial Investment outlay		-108500
3 years MACR rate			33.00%	45.00%	15.00%	7.00%
Savings			60000	60000	60000
-Depreciation	=Cost of machine*MACR%		-34320	-46800	-15600	7280	=Salvage Value
=Pretax cash flows			25680	13200	44400
-taxes	=(Pretax cash flows)*(1-tax)		16692	8580	28860
+Depreciation			34320	46800	15600
=after tax operating cash flow			51012	55380	44460
reversal of working capital					4500
+Proceeds from sale of equipment after tax	=selling price* ( 1 -tax rate)				23660
+Tax shield on salvage book value	=Salvage value * tax rate				2548
=Terminal year after tax cash flows					30708
c. Total Cash flow for the period		-108500	51012	55380	75168
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331
Discounted CF=	Cashflow/discount factor	-108500	46374.54545	45768.59504	56474.83095
d. NPV=	Sum of discounted CF=	40117.97

Accept project as NPV is positive