You must evaluate a proposal to buy a new milling machine. The base price is $10
ID: 2658149 • Letter: Y
Question
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%. The machine would require a $5,500 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 frm spent $5,000 last year investigating the feasibility of using the machine. Should the machine be purchased? HTML Editor ParagraphExplanation / Answer
Computation of Depreciation:
Cost of machine = Purchase price + Installation cost
= $ 108,000 + $ 12,500 = $ 120,500
Depreciation on year 1 = $ 120,500 x 33 % = $ 39,765
Depreciation on year 2 = $ 120,500 x 45 % = $ 54,225
Depreciation on year 3 = $ 120,500 x 15 % = $ 18,075
Computation of cash flow:
Initial investment = Cost of machine + working capital = $ 120,500 + $ 5,500 = $ 126,000
Year 1
Year 2
Year 3
Annual pre tax cost savings
$44,000
$44,000
$44,000
Less: Depreciation
$39,765
$54,225
$18,075
PBT
$4,235
($10,225)
$25,925
Less: Tax @ 35 %
$1,482.25
($3,578.75)
$9,073.75
PAT
$2,752.75
($6,646.25)
$16,851.25
Add: Depreciation
$39,765.00
$54,225.00
$18,075.00
Net cash flow
$42,517.75
$47,578.75
$34,926.25
Computation of terminal cash flow:
Salvage value
$65,000
*Less: Tax @ 35 %
$19,797.75
Working capital recovery
$5,500
Terminal Cash Flow
$50,702.25
*($ 65,000 - $ 120,500 x 0.07) x 0.35
= ($ 65,000 - $ 8,435) x 0.35 = $ 56,565 x 0.35 = $ 19,797.75
Terminal year cash flow = $ 34,926.25 + $ 50,702.25 = $ 85,628.50
Computation of NPV:
Year
Cash Flow (C)
PV Factor calculation @ 12 %
PV Factor (F)
PV (= C x F)
0
$ (126,000.00)
1/(1+12%)^0
1
($126,000.00)
1
$ 42,517.75
1/(1+12%)^1
0.892857143
$37,962.28
2
$ 47,578.75
1/(1+12%)^2
0.797193878
$37,929.49
3
$ 85,628.50
1/(1+12%)^3
0.711780248
$60,948.67
NPV
$10,840.44
Cost of $ 5,000 for investigation is sunk cost and is irrelevant for the analysis.
As NPV of machine $ 10,840 is positive, the machine should be purchased.
Year 1
Year 2
Year 3
Annual pre tax cost savings
$44,000
$44,000
$44,000
Less: Depreciation
$39,765
$54,225
$18,075
PBT
$4,235
($10,225)
$25,925
Less: Tax @ 35 %
$1,482.25
($3,578.75)
$9,073.75
PAT
$2,752.75
($6,646.25)
$16,851.25
Add: Depreciation
$39,765.00
$54,225.00
$18,075.00
Net cash flow
$42,517.75
$47,578.75
$34,926.25
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