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You must evaluate a proposal to buy a new milling machine
You must evaluate a proposal to buy a new milling machine. The base price is $117,000, 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 $64,350. The applicable depreciation rates are 33%, 45%, 15%, and 7%. 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 $44,000 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?
- 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.
- 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.
-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?
-Select-YesNoItem 6
Expert Solution
Part a) V. 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.
Part b)
Year 0 project cash outflow = New machine cost+Installation cost+Increase in working capital = $117,000+$7,000+$7,500 = $131,500
Part c)
| No | Particulars | Year 1 | Year 2 | Year 3 |
| i | Labor cost saved (given) | $ 44,000 | $ 44,000 | $ 44,000 |
| ii | Less: Depreciation ($124,000*rate) | $ 40,920 | $ 55,800 | $ 18,600 |
| iii | Net saving before tax (i-ii) | $ 3,080 | $ (11,800) | $ 25,400 |
| iv | Tax (iii*35%) | $ 1,078 | $ (4,130) | $ 8,890 |
| v | Net saving after tax (iii-iv) | $ 2,002 | $ (7,670) | $ 16,510 |
| vi | Add: Depreciation (ii) | $ 40,920 | $ 55,800 | $ 18,600 |
| vii | Sale of equipment (given) | 64,350.00 | ||
| viii | Tax on sale of equipment (vii*35%) | 22,522.50 | ||
| ix | Working capital realised (Assumed) | 7,500.00 | ||
| x | Annual cash flow (v+vi+vii-viii+ix) | $42,922.00 | $48,130.00 | $84,437.50 |
Part d)
Present value of annual cashflow = Year 1 cashflow/(1+WACC) + Year 2 cashflow/(1+WACC)^2 + Year 3 cashflow/(1+WACC)^3
= $42,922/(1+0.12) + $48,130/(1+0.12)^2 + $84,437.50/(1+0.12)^3
= $42,922/1.12 + $48,130/(1.12^2) + $84,437.50/(1.12^3)
= $38,323.21 + $48,130/1.2544 + $84,437.50/1.404928
= $38,323.21+$38,368.94+$60,100.94
= $136,793.09
Net present value (NPV) = Present value of annual cashflow - Initial cashflow = $136,793.09 - $131,500 = $5,293.09
Yes, the machine should be purchase because it gives positive NPV
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