Text book problems: Chapter 12 Problem 12-9 page 429 Fundamentals of Financial M

Question

Text book problems: Chapter 12 Problem 12-9 page 429 Fundamentals of Financial Management 14th Edition

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% as discussed in Appendix 12A. 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 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 initial investment outlay for the machine for capital budgeting purposes, that is what is the Year 0 project cash flow?

c) What are the project`s annual cash flows during Years 1,2, and 3?

d) Should the machine be purchased? Explain your answer.

Explanation / Answer

a The feasibility analysis cost of last year is a sunk cost and does not influence the cash flows from the proposed investment. So we need to ignore that cost from capital budgeting calculations. Depreciation 33% 45% 15% 7% Details Year 0 Year 1 Year 2 Year 3 Year 4 Machine base price       (108,000) Shipping & installation          (12,500) Total Machine Cost       (120,500) Depreciation                (39,765)             (54,225)             (18,075) Salvage cash Flow               65,000 Gain on asset sale               56,565 Increase in net working capital(assuming it happens in Year1)                   (5,500) b Intila Investment outlay = Year 0 cash outflow+ year 1 net working capital investment=$126,000 Increase in revenue/decrease in expense                   44,000                44,000                44,000 Less : depreciation                 (39,765)              (54,225)              (18,075) Net Income before tax                     4,235              (10,225)                25,925 Tax @35%                     1,482                  9,074 Tax on gain on asset sale                19,798 Net Income after tax(including salvage)                     2,753              (10,225)                53,619 Add back depreciation                   39,765                54,225                18,075 Total cash flow (including NWC outflow)       (120,500)                   37,018                44,000                71,694 year Year 0 Year 1 Year 2 Year 3 c Annual Cash Flows       (120,500)                   37,018                44,000                71,694 Doscount factor@12%                       1                     0.893                  0.893                  0.893 PV of cash flows       (120,500)                   33,052                39,286                64,012 NPV $        15,849 d. As NPV is positive , project may be accepted

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