You must evaluate a proposal to buy a new milling machine. The base price is $13

Question

You must evaluate a proposal to buy a new milling machine. The base price is $134,000, and shipping and installation costs would add another $16,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $60,300. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $4,000 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 $42,000 per year. The marginal tax rate is 35%, and the WACC is 14%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

A. 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.

$_____

B. 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 $_____

Explanation / Answer

(A)

Initial outlay = Base price + Shipping/installation = $(134,000 + 16,000) = $150,000

* Feasibility study expense is a sunk cost and excluded from cash flow analysis

** It is assumed that increase in net working capital is a yearly expense and not an one-time year-0 expense

(B)

Working notes:

(1) MACRS depreciation schedule as follows (Note: MACRS doesn't consider salvage value)

(2) Increase in net working capital (NWC) is assumed to be an annual expense.

(3) Pre-tax net benefit (NB), year 1 & 2 = Saving on labor cost - NWC - Depreciation (DEPR)

= $(42,000 - 4,000) - DEPR = $38,000 - DEPR

(4) Pre-tax NB, year 3 = Saving on labor cost - NWC - DEPR + Salvage value

= $(38,000 + 60,300) - DEPR = $98,300 - DEPR

*Salvage value assumed fully taxable

(5) Post-tax NB = Pre-tax NB x (1 - tax rate) = Pre-tax NB x 0.65

(6) After tax cash flow (ATCF) = Post-tax NB + DEPR (Depreciation being non-cash expense is added back)

Year Depreciation Base ($) Depreciation Rate (%) Annual depreciation ($) (A) (B) (C) = (A) x (B) 1 1,34,000 33 44,220 2 1,34,000 45 60,300 3 1,34,000 15 20,100

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