2.1 Talbot Industries is considering an expansion project. The necessary equipment could be purchased for $9 million, and the project would also require an initial $3 million investment in net operating working capital. The company’s tax rate is 40%.
- What is the initial investment outlay?
- The company spent and expensed $50,000 on research related to the project last year. Would this change your answer? Explain.
- The company plans to house the project in a building it owns but is not now using. The building could be sold for $1 million after taxes and real estate commissions. How would this affect your answer?
2.2 The Chen Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has both a book value and a market value of zero; it is in good working order, however, and will last physically for at least another 10 years. The proposed replacement machine will perform the operation so much more efficiently that Chen’s engineers estimate it will produce after tax cash flows (labor saving and depreciation) of $9,000 per year. The new machine will cost $40,000 delivered and installed, and its economic life is estimated to be 10 years. It has zero salvage value. The firm’s WACC is 10%, and its marginal tax rate is 35%. Should Chen buy the new machine?
2.3 The Campbell Company is evaluating the proposed acquisition of a new milling machine. The machine’s base price is $108,000, and it would cost another $12,500 to modify it for special use. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $65,000. The machine would require an increase in net working capital (inventory) of $5,500. The milling machine would have no effect on revenues, but it is expected to save the firm $44,000 per year in before tax operating costs, mainly labor. Campbell’s marginal tax rate is 35%.
- What is the net cost of the machine for capital budgeting purposes? (That is, what is the Year-0 net cash flow?)
- What are the net operating cash flows in Years 1, 2, and 3?
- What is the additional Year-3 cash flow (i.e., the after tax salvage and the return of working capital)?
- If the project’s cost of capital is 12%, should the machine be purchased?