You must evaluate a proposal to buy a new milling machine. The base price is $18

Question

You must evaluate a proposal to buy a new milling machine. The base price is $182,000, and shipping and installation costs would add another $13,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $91,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a %4,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, nut pretax labor costs would decline by $44,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

Explanation / Answer

Ans (a) IV - Last years expenditure is considered as sunk cost and does not represent an incremental cash flow Hence it should not be included in the analysis Ans (b) Initial Investment Outlay Machine Base Cost 182000 Shipping & Installation Cost 13000 Increase in net operating Capital 4500 Initial Investment Outlay 199500 Ans (c ) Net Operating Cash Flows Year 1 Year 2 Year 3 Pretax Profit 44000 44000 44000 Less: Marginal tax @ 35% 15400 15400 15400 Post Tax Profit 28600 28600 28600 Add: Depreciation 64350 87750 29250 Net Operating Cash Flows 92950 116350 57850 Year Cost (182000+13000) Rate 1 195000 33% 64350 2 195000 45% 87750 3 195000 15% 29250 After 3rd year 7% 13650 Ans (d) Sales Price 91000 Less: Book Value after year 3 13650 Profit before tax 77350 Less: Marginal tax @ 35% 27072.5 Profit after tax 50277.5 Add: net operating Capital 4500 Terminal year net cash flow 54777.5 10% Year Cash Flow PV Factor PV of Cash Flows 0 -199500 1 -199500 1 92950 0.909090909 84500 2 116350 0.826446281 96157.02479 3 57850 0.751314801 43463.56123 3 54777.5 0.751314801 41155.14651 NPV Cashflow 24620.58603 Since NPV is positive, machine should be purchased

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