You must evaluate a proposal to buy a new milling machine. The base price is $19
ID: 2716687 • Letter: Y
Question
You must evaluate a proposal to buy a new milling machine. The base price is $198,000, and shipping and installation costs would add another $8,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $69,300. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $8,000 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 $37,000 per year. The marginal tax rate is 35%, and the WACC is 11%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.
How should the $5,000 spent last year be handled?
I. Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
II. Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
III. The cost of research is an incremental cash flow and should be included in the analysis.
IV. Only the tax effect of the research expenses should be included in the analysis.
V. Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.
I, II, III, IV or V?
What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.
$
What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Year 1 $
Year 2 $
Year 3 $
Should the machine be purchased?
Explanation / Answer
Relevant Cost-
Relevant costs are those costs which are avoidable. These costs can be eliminated when we are choosing one alternative over another. These are also known as differential or incremental cost.
Opportunity Cost-
Opportunity costs are the cost of opportunity lost. Profit foregone by selecting one alternative over another is called opportunity cost.
Sunk Cost- These are the costs that are incurred in the past. These are irrelevant for decision making because these cannot be changed.
(‘1) Treatment of $ 5000 incurred in last year for feasibility study of machine-
As this cost is already incurred in the past, hence it is a suck cost and irrelevant for decision making while considering the investment in machinery in current year.
Hence option no II is the correct answer.
(‘2) Initial Investment in time 0
Particulars
Amount
Base price of machinery
198,000
Shipping and installation cost
8,000
Capitalised cost of machine (a)
206,000
Investment required in working capital (b)
8,000
Initial Investment Cost (a+b)
214,000
(‘3) Annual Cash flow of Projects
Particulars
Year 1
Year 2
Year 3
Depreciation
67980
92700
30900
Tax Saving on Depreciation (a)
(Depreciation x 35 %)
23,793
32,445
10,815
Saving in labor cost
37,000
37,000
37,000
Post Tax saving in labor cost (b)
( Saving x 0.65 )
24,050
24,050
24,050
Post Tax Salvage value at year 3 (c ) ( WN-2)
50,092
Release of working capital (d)
8,000
Total cash Flow (a+b+c+d)
47,843
56,495
92,957
DF @ 11 %
0.901
0.812
0.731
Present Value of Cash Flow
43,101.80
45,852.61
67,969.36
Present Value of Cash Inflow = $ 156,923.77
Intimal Investment = $ 214,000
As present value of cash flow generated from machine is less than its cost hence machine should not be purchased.
WN-1
Year 1
Year 2
Year 3
Total
Depreciation Base
206,000
206,000
206,000
Rate
33 %
45 %
15 %
Depreciation
67,980
92,700
30,900
191,580
WN-2
Original Cost
206,000
Depreciation Claimed
191,580
Book Value
14,420
Salvage Value
69,300
Gain
54,880
Tax on gain
19,208
Post tax salvage value ( sale value – tax)
50,092
Particulars
Amount
Base price of machinery
198,000
Shipping and installation cost
8,000
Capitalised cost of machine (a)
206,000
Investment required in working capital (b)
8,000
Initial Investment Cost (a+b)
214,000
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