You must evaluate a proposal to buy a new milling machine. The base price is $108,000, and shipping and installation costs would add another $12,500. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The applicable depreciation rates are 33, 45, 15 and 7 percent as discussed in Appendix 12A of your text book. The machine would require a $5,500 increase in working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pre-tax labor costs would decline by $44,000 per year. The marginal tax rate is 35 percent, and the WACC is 12 percent. 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?
The $5,000 is a sunk cost and therefore is not relevant to the analysis
- b) What is the net cost of the machine for capital budgeting purposes, that is, the Year 0 project cash flow?
Net Cost of the machine = $108,000 + $12,500 + $5,500
= $126,000
- c) What are the net operating cash flows during Years 1, 2 and 3?
| Year | ||||
| 0 | 1 | 2 | 3 | |
| After-Tax Savings | $28,600 | $28,600 | $28,600 | |
| Depreciation Tax Savings | $13,918 | $18,979 | $6,326 | |
| Net Cash Flow | $42,518 | $47,579 | $34,926 | |
- d) What is the terminal year cash flow?
| Salvage Value | $65,000 |
| Tax on Salvage Value | $19,798 |
| NWC Recovery | $5,500 |
| Terminal Cash Flow | $50,702 |
- e) Should the machine be purchased? Explain your answer.
Yes, the machine should be purchased as the investment has a positive NPV of $10,840 as per the following table.
| NPV Analysis | |||
| Year | Cash Flow | PV Factor @ 12% | PV |
| 0 | ($126,000) | 1 | ($126,000) |
| 1 | $42,518 | 0.8929 | $37,962 |
| 2 | $47,579 | 0.7972 | $37,929 |
| 3 | $85,629 | 0.7118 | $60,949 |
| NPV | $10,840 | ||
