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I: Statement of Financial Problem:
In November 1985 Paperco was presented with the critical business decision of replacing its existing mechanical drying equipment that had been originally placed into service in 1979 with more efficient equipment provided by Pressco, Inc. The consequences of this decision would have far reaching consequences as replacing the equipment could result in cost savings up to $560,000 annually. However, there were other critical factors to address before moving forward with the project.
One of the most important factors to consider was the rumored new tax legislation that would, “(1) eliminate the investment tax credit for new equipment; (2) extend depreciation lives for new equipment; and (3) reduce the corporate tax rate from 46% to 34% beginning in 1986. (Harvard, 1991)” Therefore, the financial problem facing Paperco is what is the Net Present Value (NPV) of replacing its existing mechanical drying equipment with the more efficient equipment from Pressco, assuming (1) the rumored tax legislation is enacted; (2) Paperco fails to sign the contract in time to receive the investment tax credit; and (3) the equipment is installed in December 1986. II: General Framework for Financial Analysis:
“Net Present Value (NPV) is a method of ranking investment proposals using the NPV, which is equal to the present value of the project’s free cash flows discounted at the cost of capital. (Brigham, 2009)” Simply stated the NPV of a proposed project allows organizations to determine whether or not the project is worth pursuing. It shows how much the project will contribute to shareholder wealth (Brigham, 2009). NPV is the best financial measurement tool organizations can employ in determining the potential value a project may add to the organization. Generally speaking, the higher the NPV, the more desirable the project. Conversely, a lower NPV or negative NPV should be viewed as a warning sign and the project should be rejected. The most challenging issue that arises when organizations use NPV as a method of selecting or rejecting projects, is accurately estimating future cash flows. One of the reasons this can be difficult lies in the potential complexity of a proposed project. Possible adjustments that may need to be made in order to accurately estimate future cash flows are (1) depreciation; (2) taxes (this includes tax incentives and changing tax laws); and (3) salvage values. By adjusting for these possible factors, future cash flows can be more accurately estimated and projects true NPV can be determined.
The following steps should be taken in calculating a project’s NPV – The NPV equation is illustrated in Exhibit 1 – pg 371 (Brigham, 2009): 1. “The present value of each cash flow is calculated and discounted at the project’s risk-adjusted cost of capital (or WACC), r = (___)%. 2. The sum of the discounted cash flows is defined as the project’s NPV.” Something else to consider is using NPV to compare more than one project. There are two types of projects (1) “Independent projects – projects whose cash flows are not affected by one another; (2) mutually exclusive projects – projects where if one project is accepted, the other must be rejected (Brigham, 2009).” When evaluating independent projects, the project should be accepted so long as the NPV is greater than zero. With mutually exclusive projects, the project with the higher NPV should be accepted so long as it is positive. As with any method, businesses must also consider both business and financial risk when evaluating the value proposed projects may provide to the organization. Will the implementation of the project be immune from risks such as inflation, competition, or a struggling economy? Questions such as this must be brought up, discussed, and evaluated before any project is selected for implementation. III. Application of the Financial Framework:
As Paperco calculates the NPV of replacing its existing mechanical drying equipment with the more efficient equipment from Pressco, assuming (1) the rumored tax legislation is enacted; (2) Paperco fails to sign the contract in time to receive the investment tax credit; and (3) the equipment is installed in December 1986; it must address the implications from the following activities / events illustrated in Exhibit 2: 1. Cash Outflows:
* As stated in the assumptions, the equipment payment terms are as follows: 50% ($1,050,000) with order, December 1985; 50% ($1,050,000) upon start-up of facility, December 1986. Therefore we must account for those two transactions as cash outflows in years 1985 and 1986. Additionally, there is an $800,000 installation cost that will occur during December 1986, which must also be accounted for as a cash outflow in 1986. 2. Cash Inflows:
* Tax shelter from depreciation of existing (old) equipment: i. In 1985 the cash inflow caused by the tax shelter from depreciation will be calculated using the existing 46% rate. In 1986 that tax rate will be reduced to 34% and the equipment will be sold that year so cash inflows from the old equipment will terminate that same year. * Tax shelter from depreciation of new equipment:
ii. Since the new equipment will be installed in 1986, the new tax rate of 34% will be used to calculate cash inflows from the tax shelter from depreciation of the new equipment. This will continue through the allowed depreciation period of 7 years (1993) according to the Modified Accelerated Cost Recovery System (MACRS). * After tax impact of cost savings:
iii. The annual cost savings from the installation of the new equipment are estimated to be $560,000. In order to calculate the tax impact of cost savings we utilize a rate of 66% (100% – 34% tax rate) and multiply that by the $560,000. May it be noted that these savings will not begin occurring until the equipment has been in use for an entire year and the old equipment is no longer being used (1986).
* Proceeds from equipment disposal after taxes:
iv. In 1986 the existing equipment will be sold, which will have an estimated market value of $150,000 (Table A). This cash inflow will have a positive effect on net cash flow for 1986. v. In 1996 the new equipment will be sold, which will have an estimated salvage value at the end of its useful life of $250,000 (Table B). This cash inflow will also have a positive effect on net cash flow for 1996. Calculation of NPV based on cash inflows and outflows:
In order to calculate the NPV for the project the sum of the net cash flows for each year must be calculated and multiplied by the present value factor (Table C) for the given cash flow year at 12%. May it be noted that 1985 is considered year 0 and will have a present value factor of 1. Once each years NPV has been calculated, the sum of each year’s NPV is calculated to give us the total NPV for the project, which in this case is equal to $95,680. Since the NPV of the project is greater than zero the project should be accepted. IV. Assumptions and Special / Mitigating Circumstances:
* Equipment cost: $2,100,000.
* The reduction in the corporate tax rate from 46% to 34%. * The use of the Modified Accelerated Cost Recovery System (MACRS) in accounting for depreciation. * Start-up of facility: December 1986, 12 months after receipt of order, which was anticipated in December 1985. * The elimination of the investment tax credit for new equipment. * Equipment payment terms: 50% ($1,050,000) with order, December 1985; 50% ($1,050,000) upon start-up of facility, December 1986. * Paperco cost of capital: 12%.
* Depreciable life and estimated salvage value presented in Table A and Table B are presumed to be accurate. * Physical life of new facility (after start-up): 10 years. V. Conclusions and Recommendations:
In conclusion, the Net Present Value (NPV) of replacing Paperco’s existing mechanical drying equipment with the more efficient equipment from Pressco, assuming (1) the rumored tax legislation is enacted; (2) Paperco fails to sign the contract in time to receive the investment tax credit; and (3) the equipment is installed in December 1986 is $95,680. Since the proposed project’s NPV is greater than zero, the project should be accepted. Even with the confidence provided by a positive NPV, Paperco must consider possible business and financial risks that may result due to accepting the project and moving forward. As mentioned in the case, management was particularly concerned that the rumored tax legislation may have a negative effect on sales. This concern as well as any others must be identified and discussed before moving forward on the project’s positive NPV alone.