Question

You must evaluate a proposal to buy a new milling machine. The purchase price of the milling machine, including shipping and installation costs, is $122,000, and the equipment will be fully depreciated at the time of purchase. The machine would be sold after 3 years for $47,000. The machine would require a $7,500 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 $30,000 per year. The marginal tax rate is 25%, and the WACC is 8%. Also, the firm spent $4,500 last year investigating the feasibility of using the machine.

1. How should the $4,500 spent last year be handled?
   1. The cost of research is an incremental cash flow and should be included in the analysis.
   2. Only the tax effect of the research expenses should be included in the analysis.
   3. 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.
   4. 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.
   5. 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.
   =____
   
2. What is the initial investment outlay for the machine for capital budgeting purposes after the 100% bonus depreciation is considered, that is, what is the Year 0 project cash flow? Enter your answer as a positive value. Round your answer to the nearest dollar.
   $  
   
3. 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 dollar.
   Year 1: $___  
   Year 2: $___
   Year 3: $___
   
4. Should the machine be purchased? ___

Answer 1

Last year expense will be treated as sunk cost. This expense is already incurred and whether project is accepted or rejected, the amount already spent is not going to
come back so this cost is treated as sunk cost.
Tax rate		25%
Calculation of annual depreciation
Depreciation		Year-1	Year-2	Year-3			Total
Cost		$       122,000	$      122,000	$       122,000
Dep Rate		100.00%	0.00%	0.00%
Depreciation	Cost * Dep rate	$       122,000	$                -	$                 -			$       122,000
Calculation of after-tax salvage value
Cost of machine			$      122,000
Depreciation			$      122,000
WDV	Cost less accumulated depreciation	$                -
Sale price			$        47,000
Profit/(Loss)	Sale price less WDV	$        47,000
Tax	Profit/(Loss)*tax rate	$        11,750
Sale price after-tax	Sale price less tax		$        35,250
Calculation of annual operating cash flow
		Year-1	Year-2	Year-3
Saving in labor cost		$         30,000	$        30,000	$         30,000
Less: Depreciation		$       122,000	$                -	$                 -
Profit before tax (PBT)		$       (92,000)	$        30,000	$         30,000
Tax@25%	PBT*Tax rate	$       (23,000)	$          7,500	$           7,500
Profit After Tax (PAT)	PBT - Tax	$       (69,000)	$        22,500	$         22,500
Add Depreciation	PAT + Dep	$       122,000	$                -	$                 -
Cash Profit after-tax		$         53,000	$        22,500	$         22,500
Calculation of NPV
						8.00%
Year		Capital	Working capital	Operating cash	Annual Cash flow	PV factor, 1/(1+r)^time	Present values
0		$     (122,000)	$         (7,500)		$     (129,500)	1.0000	$     (129,500)
1				$         53,000	$         53,000	0.9259	$         49,074
2				$         22,500	$         22,500	0.8573	$         19,290
3		$         35,250	$          7,500	$         22,500	$         65,250	0.7938	$         51,798
					Net Present Value	$         (9,338)
Since NPV is negative, the machine should not be purchased.