You must evaluate a proposal to buy a new milling machine. Thebase price is $140,000, and shipping and installation costs wouldadd another $14,000. The machine falls into the MACRS 3-year class,and it would be sold after 3 years for $91,000. The applicabledepreciation rates are 33%, 45%, 15%, and 7%. The machine wouldrequire a $10,000 increase in net operating working capital(increased inventory less increased accounts payable). There wouldbe no effect on revenues, but pretax labor costs would decline by$35,000 per year. The marginal tax rate is 35%, and the WACC is11%. Also, the firm spent $5,000 last year investigating thefeasibility of using the machine.
a. How should the $5,000 spent last year be handled?
- Last year's expenditure is considered as a sunk cost and doesnot represent an incremental cash flow. Hence, it should not beincluded in the analysis.
- The cost of research is an incremental cash flow and should beincluded in the analysis.
- Only the tax effect of the research expenses should be includedin the analysis.
- Last year's expenditure should be treated as a terminal cashflow and dealt with at the end of the project's life. Hence, itshould not be included in the initial investment outlay.
- Last year's expenditure is considered as an opportunity costand does not represent an incremental cash flow. Hence, it shouldnot be included in the analysis.
b.What is the initial investment outlay for the machine forcapital budgeting purposes, that is, what is the Year 0 projectcash flow? Round your answer to the nearest cent.
c. What are the project's annual cash flows during Years 1, 2,and 3? Round your answer to the nearest cent.
d. Should the machine be purchased?
