Reference no: EM132949956
You must evaluate a proposal to buy a new milling machine. The base price is $111,000, and shipping and installation costs would add another $8,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $49,950. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $8,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $54,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $4,500 last year investigating the feasibility of using the machine.
Question 1: How should the $4,500 spent last year be handled?
Option 1: Only the tax effect of the research expenses should be included in the analysis.
Option 2: Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.
Option 3: Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
Option 4: Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.
Option 5: The cost of research is an incremental cash flow and should be included in the analysis.
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