New project analysis 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 percent. 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 pre-tax labor costs would decline by $44,000 per year. The marginal tax rate is 35 percent, and the WACC is 12 percent. 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. What is the net cost of the machine for capital budgeting purposes, that is, the Year 0 project cash flow?

c. What are the net operating cash flows during Years 1, 2, and 3?

d. What is the terminal year cash flow?

e. Should the machine be purchased?

Explain your answer.

a. The $5,000 spent last year should be treated as an expense in the current year and should not be included in the capital budgeting analysis.

b. The net cost of the machine for capital budgeting purposes is $120,500, which is the base price of $108,000 plus the shipping and installation costs of $12,500.

c. The net operating cash flows during Years 1, 2, and 3 are $44,000, $44,000, and $44,000, respectively. This is calculated by subtracting the pre-tax labor costs of $44,000 from the depreciation expense of $36,240, $48,360, and $16,200 for Years 1, 2, and 3, respectively.

d. The terminal year cash flow is $65,000, which is the sale price of the machine.

e. The machine should be purchased. The net present value of the project is $14,945. This is calculated by discounting the net cost of the machine and the net operating cash flows for Years 1, 2, and 3 at the WACC of 12%, and then subtracting the terminal year cash flow of $65,000. Since the net present value is positive, the machine should be purchased.

a. The $5,000 spent last year investigating the feasibility of using the machine should be treated as a sunk cost and not considered in the analysis. It is non-recoverable and not relevant to the decision-making process.

b. The net cost of the machine for capital budgeting purposes, or the Year 0 project cash flow, can be calculated by adding the base price, shipping and installation costs, and the increase in working capital, and subtracting the salvage value of the machine at the end of Year 3.

Net cost = Base price + Shipping and installation costs + Increase in working capital - Salvage value
Net cost = $108,000 + $12,500 + $5,500 - $65,000
Net cost = $61,000

c. The net operating cash flows during Years 1, 2, and 3 can be calculated by subtracting the depreciation expense, the decline in labor costs, and the taxes from the annual revenues.

Net operating cash flow = Revenues - Depreciation expense - Labor cost savings - Taxes

Year 1: Net operating cash flow = Revenues - (33% * $108,000) - $44,000 - (35% * (Revenues - (33% * $108,000) - $44,000))
Year 2: Net operating cash flow = Revenues - (45% * $108,000) - $44,000 - (35% * (Revenues - (45% * $108,000) - $44,000))
Year 3: Net operating cash flow = Revenues - (15% * $108,000) - $44,000 - (35% * (Revenues - (15% * $108,000) - $44,000))

d. The terminal year cash flow is the cash flow generated from selling the machine at the end of Year 3, which is equal to the salvage value.

Terminal year cash flow = Salvage value
Terminal year cash flow= $65,000

e. To determine whether the machine should be purchased, we need to calculate the project's net present value (NPV) using the WACC (12%) as the discount rate. If the NPV is positive, the machine should be purchased; if it's negative, it should not be.

By calculating the cumulative net cash flows over the project's lifespan (including the initial cost and the annual operating cash flows) and discounting them back to present value, we can compare the sum to the initial investment.

If the NPV is greater than zero, it means the project will generate more value than its cost and should be pursued. Otherwise, if the NPV is negative, the project would not be financially viable.

Therefore, by evaluating the NPV from the analysis, we can determine whether the machine should be purchased.

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 incurred in the past and cannot be changed, so they should not be considered when making decisions about the future. Therefore, the $5,000 spent last year should not be included in the analysis.

b. To calculate the net cost of the machine for capital budgeting purposes, we need to subtract the salvage value (resale value) of the machine from the initial cost. The net cost of the machine can be calculated as follows:

Net cost = Base price + Shipping and installation costs - Salvage value
Net cost = $108,000 + $12,500 - $65,000
Net cost = $55,500

So, the net cost of the machine for capital budgeting purposes is $55,500.

c. To calculate the net operating cash flows during Years 1, 2, and 3, we need to consider the changes in labor costs, working capital, and depreciation. The net operating cash flows for each year will be calculated as follows:

Year 0: There is no cash flow in Year 0 as it represents the initial investment.

Year 1:
Net operating cash flow = (Pre-tax labor cost savings + Depreciation) * (1 - Tax rate) + Change in working capital
Net operating cash flow = ($44,000 + ($108,000 * 33%)) * (1 - 35%) + $5,500

Year 2:
Net operating cash flow = (Pre-tax labor cost savings + Depreciation) * (1 - Tax rate) + Change in working capital
Net operating cash flow = ($44,000 + ($108,000 * 45%)) * (1 - 35%) + $5,500

Year 3:
Net operating cash flow = (Pre-tax labor cost savings + Depreciation) * (1 - Tax rate) + Change in working capital + Salvage value
Net operating cash flow = ($44,000 + ($108,000 * 15%)) * (1 - 35%) + $5,500 + $65,000

d. The terminal year cash flow represents the cash flow generated when the machine is sold at the end of Year 3. The terminal year cash flow is equal to the salvage value of the machine ($65,000).

e. To determine whether the machine should be purchased, we need to compare the present value of the net cash flows to the initial investment (net cost of the machine).

If the present value of the net cash flows is greater than the initial investment, then the machine should be purchased because it would generate more value than the cost. On the other hand, if the present value of the net cash flows is less than the initial investment, then the machine should not be purchased as it would not create enough value to justify the cost.

To perform this analysis, we need to calculate the present value of the net cash flows and compare it to the net cost of the machine. If the present value is greater, then the machine should be purchased.

The decision to purchase the machine depends on the outcome of this analysis.

a. The $5,000 spent last year 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 in the decision-making process for the new project.

b. To calculate the net cost of the machine for capital budgeting purposes, we need to consider the base price, shipping and installation costs, and the increase in working capital. The net cost can be calculated as follows:

Net Cost = Base Price + Shipping and Installation Costs + Increase in Working Capital
Net Cost = $108,000 + $12,500 + $5,500
Net Cost = $126,000

Therefore, the Year 0 project cash flow, or the net cost of the machine for capital budgeting purposes, is $126,000.

c. To calculate the net operating cash flows during Years 1, 2, and 3, we need to consider the depreciation, changes in working capital, and tax effects. The net operating cash flows can be calculated as follows:

Net Operating Cash Flow = (Depreciation + Change in Working Capital + Labor Cost Savings) * (1 - Tax Rate)

For Year 1:
Depreciation = Net Cost * Depreciation Rate = $126,000 * 33% = $41,580
Change in Working Capital = $5,500
Labor Cost Savings = $44,000
Tax Rate = 35%

Net Operating Cash Flow (Year 1) = ($41,580 + $5,500 + $44,000) * (1 - 0.35)

Perform similar calculations for Years 2 and 3 using the relevant depreciation rates.

d. The terminal year cash flow is the cash flow generated from the selling of the machine after 3 years. It can be calculated as follows:

Terminal Year Cash Flow = Sales Proceeds - Tax on Sales Proceeds

Sales Proceeds = Selling Price of Machine = $65,000
Tax on Sales Proceeds = (Selling Price - Book Value) * Tax Rate

Book Value = Net Cost - Accumulated Depreciation

Calculate the book value based on the accumulated depreciation for the 3 years using the relevant depreciation rates. Then calculate the tax on sales proceeds and subtract it from the sales proceeds to obtain the terminal year cash flow.

e. To determine whether the machine should be purchased, we need to analyze the net present value (NPV) of the project. NPV compares the present value of net cash flows to the initial investment.

Calculate the net cash flows for each year by subtracting the taxes from the net operating cash flows. Then discount them to present value using the weighted average cost of capital (WACC). Finally, sum up the present values and subtract the initial investment (Year 0 project cash flow) to get the NPV.

If the NPV is positive, it indicates that the present value of the cash inflows is greater than the initial investment, and the project should be accepted. If the NPV is negative, it means the opposite.

Consider other factors such as strategic importance, future growth prospects, and potential competitive advantages before making the final decision.