Problem: You must compute a proposal to purchase a new milling machine. The base price is $165,000, and installation and shipping costs would add another $19,000. The machine falls in the MACRS 3 year class, and it would be sold after three years for $57,750. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would need a $9,500 raise in net operating working capital (raised inventory less increased accounts payable). There would be no consequence on revenues however pre-tax labour costs would decline by $45,000 per year. The marginal tax rate is 35%, and the WACC is 11%. Also, the firm spent $5,000 previous year investigating the feasibility of using the machine.
problem1. How must the $5,000 spent last year be handled?
i) Last year's expenses is considered a sunk cost and does not represent the incremental cash flow. Hence, it must not be included in analysis.
ii) The cost of research is incremental cash flow and must be included in analysis.
iii) Only the tax cause of the research expenses should be included in the analysis.
iv) 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 must not be included in initial investment outlay.
v) Last year's expenses is considered an opportunity cost and doesn’t represent an incremental cash flow. Thus, it must not be included in analysis.
problem2. What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is Year 0 project cash flow?
problem3. What are the project's annual cash flows throughout Years 1, 2, and 3?
Year 1 $
Year 2 $
Year 3 $
problem4. Should the machine be bought?