New project analysis 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. 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?
b. What is the net cost of the machine for capital budgeting purposes, that is, the Year
0 project cash flow?
c. What are the net operating cash flows during Years 1, 2, and 3?
d. What is the terminal year cash flow?
e. Should the machine be purchased? Explain your answer.
Please don't keep posting the same question. At least wait a few hours before reposting.
Hint: You'd have a much better chance of receiving an answer if you showed us the work you've done so far on this problem.
We don't DO your homework, but are glad to HELP you.
find the depreciation of the machine which is $20166.67
then year 1 you less the depreciation from the cost which is $120500
you add the increase in working capital plus the labor costs after tax
a. The $5,000 spent last year on investigating the feasibility of using the machine should be treated as a sunk cost. Sunk costs are unrecoverable costs that have already been incurred and should not be considered in the decision-making process.
b. To calculate the net cost of the machine for capital budgeting purposes (Year 0 project cash flow), we need to add the base price, shipping and installation costs, and the increase in working capital, and subtract the salvage value of the machine.
Net cost = Base price + Shipping and installation costs + Increase in working capital - Salvage value
Net cost = $108,000 + $12,500 + $5,500 - $65,000
Net cost = $61,000
c. To calculate the net operating cash flows during Years 1, 2, and 3, we need to consider the decrease in labor costs and the depreciation expense. The depreciation expenses are given by the MACRS rates applied to the net cost of the machine.
Year 1:
Depreciation expense = Net cost * Depreciation rate for Year 1
Depreciation expense = $61,000 * 33%
Depreciation expense = $20,130
Net operating cash flow = Pre-tax labor cost savings + Depreciation expense
Net operating cash flow = $44,000 + $20,130
Net operating cash flow = $64,130
Year 2:
Depreciation expense = Net cost * Depreciation rate for Year 2
Depreciation expense = $61,000 * 45%
Depreciation expense = $27,450
Net operating cash flow = Pre-tax labor cost savings + Depreciation expense
Net operating cash flow = $44,000 + $27,450
Net operating cash flow = $71,450
Year 3:
Depreciation expense = Net cost * Depreciation rate for Year 3
Depreciation expense = $61,000 * 15%
Depreciation expense = $9,150
Net operating cash flow = Pre-tax labor cost savings + Depreciation expense
Net operating cash flow = $44,000 + $9,150
Net operating cash flow = $53,150
d. The terminal year cash flow is the combination of the pre-tax labor cost savings and the salvage value of the machine.
Terminal year cash flow = Pre-tax labor cost savings + Salvage value
Terminal year cash flow = $44,000 + $65,000
Terminal year cash flow = $109,000
e. To determine whether the machine should be purchased, we need to calculate the net present value (NPV) of the cash flows and compare it with zero. If the NPV is positive, it indicates that the project is expected to generate a profit and should be pursued.
NPV (WACC, cash flows) = -Net cost + Net cash flows / (1 + WACC)^t
Where t is the number of years (1, 2, 3, and terminal year).
By calculating the NPV and comparing it with zero, we can make a decision on whether to purchase the machine.
To evaluate whether the new milling machine should be purchased, we need to calculate the relevant cash flows and use those in various capital budgeting techniques. Let's go through each question step-by-step:
a. How should the $5,000 spent last year be handled?
The $5,000 spent last year for investigating the feasibility of using the machine is a sunk cost and should not be considered in the capital budgeting analysis. Since it has already been incurred and cannot be recovered, it does not impact the decision-making process.
b. What is the net cost of the machine for capital budgeting purposes, that is, the Year 0 project cash flow?
The net cost of the machine for capital budgeting purposes includes the base price, shipping and installation costs, and the increase in working capital. In this case, the net cost is calculated as follows:
Net cost = Base price + Shipping and installation costs + Increase in working capital
Net cost = $108,000 + $12,500 + $5,500
Net cost = $126,000
Therefore, the Year 0 project cash flow is -$126,000.
c. What are the net operating cash flows during Years 1, 2, and 3?
To calculate the net operating cash flows during Years 1, 2, and 3, we need to consider the changes in labor costs, depreciation, and taxes. The steps for each year are as follows:
Year 1:
Net operating cash flow = (Annual labor cost savings + Depreciation expense) * (1 - Tax rate)
Net operating cash flow = ($44,000 + Depreciation expense) * (1 - 0.35)
Year 2:
Net operating cash flow = (Annual labor cost savings + Depreciation expense) * (1 - Tax rate)
Net operating cash flow = ($44,000 + Depreciation expense) * (1 - 0.35)
Year 3:
Net operating cash flow = (Annual labor cost savings + Depreciation expense + Terminal salvage) * (1 - Tax rate)
Net operating cash flow = ($44,000 + Depreciation expense + $65,000) * (1 - 0.35)
The depreciation expenses for each year can be calculated using the MACRS depreciation rates:
Year 1: Depreciation expense = Base price * Depreciation rate for Year 1
Year 2: Depreciation expense = Base price * Depreciation rate for Year 2
Year 3: Depreciation expense = Base price * Depreciation rate for Year 3
d. What is the terminal year cash flow?
The terminal year cash flow is the net cash flow resulting from selling the machine after 3 years. In this case, the terminal year cash flow is the selling price minus the tax on the salvage value:
Terminal year cash flow = (Selling price - Tax on salvage value)
Terminal year cash flow = ($65,000 - (Tax rate * $65,000))
e. Should the machine be purchased? Explain your answer.
To determine whether the machine should be purchased, we need to evaluate the net present value (NPV) of the project. The NPV is calculated by discounting the net cash flows using the weighted average cost of capital (WACC).
NPV = Year 0 project cash flow + (Net operating cash flow Year 1 / (1 + WACC)^1) + (Net operating cash flow Year 2 / (1 + WACC)^2) + (Net operating cash flow Year 3 + Terminal year cash flow / (1 + WACC)^3)
If the NPV is positive, it indicates that the project is expected to generate more cash inflows than the initial investment, making it financially viable. If the NPV is negative, it suggests that the project may not generate sufficient returns to cover the investment, and it may not be a wise decision.
Based on the NPV analysis, if the NPV is positive, it is recommended to purchase the machine, and if it is negative, it is not recommended.
By following the steps mentioned above and plugging in the values provided in the problem, you can calculate the net cost, net operating cash flows, terminal year cash flow, and determine whether the machine should be purchased or not.