XYZ Inc. needs to install a new manufacturing machine. The base price is $100,00

Question

XYZ Inc. needs to install a new manufacturing machine. The base price is $100,000. Installation costs are $10,000. After 3 years the machine will be sold for $75,000. Applicable depreciation rates are 33 percent, 45 percent, 15 percent, and 7 percent. The machine would require a $5,000 increase in net operating working capital (increased inventory less increased accounts payables). Revenue would not be affected. Pretax labor costs would decline by $40,000 per year. The marginal tax rate is 40 percent, and the WACC is 10 percent. Also, the firm spent $7,000 in feasibility tests.

1. $7,000 was spent last year. How should this be handled?

2. For capital budgeting purposes, what is the initial investment outlay for the machine? That is, what is the Year 0 project cash flow?

Is this correct? Am I missing anything?

Since the $7k was for feasibilty testis, there are "sunk costs" that will nobe recovered. This are not relevant to the capital budgeting decisions and cannot be recovered. Base price + Installation + $5k to increase working capital makes Cash Flow @ Year 0 $115,000.

Explanation / Answer

1) $ 7000 is sunk costs hence it is ignored and not considered when making a decision to continue investing in an ongoing project.

2) Initial investment outlay= 100,000+ $10,000 + $ 5000 working capital = $ 115,000

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