Quiz8_A(Answers)

Quiz8_A(Answers) - BADM 115 – Section 11 Prof. Isabelle...

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Unformatted text preview: BADM 115 – Section 11 Prof. Isabelle Bajeux‐Besnainou Fall 2008 Form A QUIZ #8 You must evaluate a proposal to buy a new milling machine. The base price is $211,000, and shipping and installation costs would add another $18,500. The machine falls into the MACRS 3‐year class, and it would be sold after 3 years for $88,000. The applicable depreciation rates are listed in Table 1. The machine would require a $9,300 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 $120,000 per year. The marginal tax rate is 40 percent, and the WACC is 10 percent. Also, the firm spent $11,600 last year investigating the feasibility of using the machine. Table 1 Ownership Year 1 2 3 4 5 6 7 8 9 10 11 3‐Year 33% 45% 15% 7% 100% Recovery Allowance Percentage for Personal Property CLASS OF INVESTMENT 5‐Year 7‐Year 20% 14% 32% 25% 19% 17% 12% 13% 11% 9% 6% 9% 9% 4% 100% 100% 10‐Year 10% 18% 14% 12% 9% 7% 7% 7% 7% 6% 3% 100% a. (1 point) How should the $11,600 spent last year be handled? The $11,600 spent last year on exploring the feasibility of the project is a sunk cost and should not be included in the analysis. b. (2 points) What is the net cost of the machine for capital budgeting purposes, that is, the Year 0 project cash flow? The net cost is $238,800: Price ($211,000) Modification (18,500) Increase in NOWC (9,300) Cash outlay for new machine ($238,800) A ‐ 1 c. (3 points) What are the net operating cash flows during Years 1, 2, and 3? The operating cash flows follow: Year 1 Year 2 Year 3 1. After‐tax savings $72,000 $72,000 $72,000 2. Depreciation tax savings $30,294 $41,310 $13.770 Net cash flow $102,294 $113,310 $85,770 Notes: 1. The after‐tax cost savings is $120,000(1 – T) = $120,000(0.6) = $72,000. 2. The depreciation expense in each year is the depreciable basis, $229,500, times the MACRS allowance percentages of 0.33, 0.45, and 0.15 for Years 1, 2, and 3, respectively. Depreciation expense in Years 1, 2, and 3 is $75,735, $103,275, and $34,425. The depreciation tax savings is calculated as the tax rate (40%) times the depreciation expense in each year. d. (2 points) What is the terminal year cash flow? The terminal cash flow is $68,526: Salvage value $88,000 Tax on SV* (28,774) 9,300 Return of NOWC $68,526 *Tax on SV = ($88,000 – $16,065)(0.4) = $28,774. BV in Year 4 = $229,500(0.07) = $16,065. e. (2 points) Should the machine be purchased? Explain your answer. The project has an NPV of $8,556; thus, it should be accepted. Year Net Cash Flow PV @ 10% 0 ($238,800) ($238,800) 1 102,294 92,995 2 113,310 93,645 3 154,296 115,925 $63,764 Alternatively, place the cash flows on a time line: 0 1 2 3 | | | | ‐238,800 102,294 113,310 85,770 68,526 154,296 With a financial calculator, input the appropriate cash flows into the cash flow register, input I/YR = 10, and then solve for NPV = $63,764. A ‐ 2 ...
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