Question

NEW PROJECT ANALYSIS You must evaluate a proposal to buy a new milling machine. The base price is $195,000, 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 $87,750. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $8,500 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 $54,000 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 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. II. 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. III. 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. IV. The cost of research is an incremental cash flow and should be included in the analysis. V. Only the tax effect of the research expenses should 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 O 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. Do not round your intermediate calculations. Year 1 $ Year 2 $ Year 3 $

Answer 1

a.III.Sunk cost, not included
a.Initial Investment Outlay = Base Price + Modification cost + Increase in Working Capital
=-195000-17000-8500
(220,500)	since outflow
b.Annual Cash Flows:
	Year 1	2	3
Savings in Cost	54,000	54,000	54,000
Less: Depreciation	69,960	95,400	31,800
Net Savings	-15,960	-41,400	22,200
Less: Tax @35%	-5,586.00	-14,490.00	7,770.00
Income after Tax	-10,374.00	-26,910.00	14,430.00
Add: Depreciation	69,960	95,400	31,800
Operating Cash Flow	59,586.00	68,490.00	46,230.00
Add: After tax salvage value			62,231.50
Recovery of Working capital			8,500
Additional cash flows			70,732
Annual Cash Flow	59,586.00	68,490.00	116,961.50
Written down value	14,840
Sale price	87750
Gain on sale	72,910
Tax	25518.5
After tax salvage value	62231.5
c.NPV = Present value of cash inflows – present value of cash outflows
= 59586*PVF(14%, 1 year) + 68,490*PVF(14%, 2 years) + 116,961.50*PVF(14%, 3 years) – 220500
-36585.06693
No, should not be purchased (since NPV is negative)