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 as
discussed in Appendix 12A. 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?
The $5,000 is a sunk cost and therefore is not relevant to the analysis
b. What is the net cost of the machine for capital budgeting purposes, that is, the Year 0
project cash flow?
Net Cost of the machine = $108,000 + $12,500 + $5,500
= $126,000
c. What are the net operating cash flows during Years 1, 2, and 3?
0
After-Tax Savings
Depreciation Tax Savings
Net Cash Flow
1
$28,600
$13,918
$42,518
Year
2
$28,600
$18,979
$47,579
3
$28,600
$6,326
$34,926
d. What is the terminal year cash flow?
Salvage Value
Tax on Salvage Value
NWC Recovery
Terminal Cash Flow
$65,000
$19,798
$5,500
$50,702
e. Should the machine be purchased? Explain your answer.
Yes, the machine should be purchased as the investment has a positive NPV of
$10,840 as per the following table.
Year
0
1
2
3
NPV
Cash Flow
($126,000)
$42,518
$47,579
$85,629
NPV Analysis
PV Factor @ 12%
1
0.8929
0.7972
0.7118
PV
($126,000)
$37,962
$37,929
$60,949
$10,840
Q-2. Would each of the following increase, decrease, or have an in determinant effect on
a firm’s breakeven point (unit sales)?
a. An increase in the sales price with no change in unit costs.
BEP in unit sales will decrease
b. An increase in fixed costs accompanied by a decrease in variable costs.
Indeterminant effect, it depends on the amount of increase in fixed costs and
decrease in variable costs.
c. A new firm decides to use MACRS depreciation for both book and tax purposes rather
than the straight-line depreciation method.
BEP in unit sales will increase since MACRS would lead to more Variable Cost per
unit, consequently, the Unit Contribution Margin will decrease leading to an
increase in BEP.
d. Variable labor costs decline; other things are held constant.
BEP in unit sales will decrease, since a decrease in VC would lead to a higher Unit
Contribution Margin