2. You must evaluate a proposal to buy a new milling machine. The base price is $108,000, and shipping and installation costs would add another $12,500. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $5,500 increase in working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $44,000 per year. The marginal tax rate is 35%, and the WACC is 12%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

Question

2. You must evaluate a proposal to buy a new milling machine. The base price is $108,000, and shipping and installation costs would add another $12,500. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $5,500 increase in working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $44,000 per year. The marginal tax rate is 35%, and the WACC is 12%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

a. How should the $5,000 spent last year be handled?
b. Should the machine be purchased?

Answer 1

a. The $5,000 spent last year on investigating the feasibility of using the machine should be treated as a sunk cost. Sunk costs are costs that have already been incurred and cannot be recovered. They should not be considered when evaluating whether or not to purchase the machine. Therefore, the $5,000 should be disregarded in the decision-making process.

b. To determine whether the machine should be purchased, we need to analyze the net present value (NPV) of the investment. Here are the steps to calculate the NPV:

Step 1: Calculate the initial investment:
- Base price: $108,000
- Shipping and installation costs: $12,500
- Increase in working capital: $5,500
Total initial investment = $108,000 + $12,500 + $5,500 = $126,000

Step 2: Calculate the annual after-tax cash flows for the 3-year period:
- Pretax labor cost savings: $44,000 per year
- Tax rate: 35%
- After-tax labor cost savings: $44,000 * (1 - 0.35) = $28,600 per year

Step 3: Determine the depreciation expense and calculate the annual tax shield:
- MACRS depreciation rates: 33%, 45%, 15%, and 7% for the 4 years
- Depreciation expense for each year: Multiply the base price by the corresponding depreciation rate for that year
- Tax shield for each year: Depreciation expense * tax rate

Step 4: Calculate the annual after-tax cash flows, including the tax shield:
- Annual after-tax cash flow = after-tax labor cost savings + tax shield from depreciation

Step 5: Calculate the salvage value after 3 years:
- Sell the machine for $65,000

Step 6: Calculate the present value of each year's cash flow:
- Discount rate (WACC): 12%
- Use the formula: Present value = Cash flow / (1 + discount rate)^year

Step 7: Calculate the NPV:
- NPV = Initial investment + Present value of annual cash flows + Present value of salvage value

If the NPV is positive, it means that the investment is expected to generate more cash inflows than outflows and is therefore financially beneficial. If the NPV is negative, it indicates that the investment is not expected to generate enough cash inflows to cover the initial investment and should be avoided.

By following these steps and performing the calculations, you can determine whether the machine should be purchased based on the NPV of the investment.