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.

Question

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. 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.

Answer 1

a. The $5,000 spent last year should be treated as an expense in the current year and should not be included in the capital budgeting analysis.

b. The net cost of the machine for capital budgeting purposes is $120,500, which is the base price of $108,000 plus the shipping and installation costs of $12,500.

c. The net operating cash flows during Years 1, 2, and 3 are $44,000, $44,000, and $44,000, respectively. This is calculated by subtracting the pre-tax labor costs of $44,000 from the depreciation expense of $36,240, $48,360, and $16,200 for Years 1, 2, and 3, respectively.

d. The terminal year cash flow is $65,000, which is the sale price of the machine.

e. The machine should be purchased. The net present value of the project is $14,945. This is calculated by discounting the net cost of the machine and the net operating cash flows for Years 1, 2, and 3 at the WACC of 12%, and then subtracting the terminal year cash flow of $65,000. Since the net present value is positive, the machine should be purchased.