Pressco,Inc.

(1985) Case Study

RASMITA MISRA FDM Fall 2011

Memo
Recommendation I recommend Paperco to accept the first option where the rumored tax proposal is not enacted in order to maximize their profits. Rationale for Decision I start by laying out data as per the details known from the Pressco inc. business case. Based on stated assumptions, I present an analysis as it relates to the decision of accepting the case by Paperco. The issue in this case study is should Paperco buy the new machine? The suggested questions in order to find the solution are:What is the net present value of the mechanical drying equipment investment opportunity (as of December 1985) assuming a 12% cost of capital for Paperco? Assume the rumored new tax proposal is not enacted and that the new drying equipment replaces the old in December 1986. What is the net present value of the investment opportunity assuming that (a) the new tax proposals are enacted, (b) the new drying equipment replaces the old in December 1986, and (c) Paperco signs a binding purchase contract soon enough to be grandfathered as to the 8% investment tax credit and the use of ACRS depreciation? What is the net present value of the investment opportunity assuming that (a) the new tax proposals are enacted, (b) the new drying equipment replaces the old in December 1986, and (c) Paperco does not sign a binding purchase contract soon enough to be grandfathered as to the 8% investment tax credit and the use of ACRS depreciation? All the figures in ($000s) The Solution:The first option assumes that the rumored tax proposal is not enacted and that the new drying equipment replaces the old in December 1986. Paperco would retain all tax credits due to the fact the machine has been in service for 84 months, and continue to use a 5 yr ACRS depreciation model. This option has a positive NPV of $79.78. The second option assumes that the new tax proposal is enacted. The new drying equipment is installed in December 1986. Paperco signs a binding contract soon enough to be grandfathered, this allows Paperco to receive the 8% tax credit and use ACRS depreciation. At the same time, their tax rate would fall to 34%. Paperco would benefit from this more favorable grandfathered tax approach. Option two has a positive NPV of $ 194.37.

The third option assumes that the new tax proposal is enacted and Paperco installs the new equipment in December 1986, but they do not sign a binding contract in time to be grandfathered and receive the 8% investment tax credit and use ACRS depreciation. The company will use MACRS and a depreciation period of 7 years. The NPV of the project drops to a negative $38.37. Without the grandfathered tax allowance the new tax legislation makes the project less beneficial than the old tax law. The estimated annual cost saving produced by the mechanical drying equipment is subject to errors in engineering estimates of as much as 10%. The annual cost saving could range anywhere from $504,000 to $ 616,000. Since this issue would inevitably arise in the presentation to Papercos management, Ms. Rogers wondered how small the annual cost savings could become before the project would be uneconomic for Paperco.Paperco is faced with three options: new legislation is passed and they qualify for grandfathering, new legislation is passed and they do not qualify for grandfathering, or no new legislation is enacted. The lowest annual cost savings in the options for the project are $537,983, $540,536, and $548,209. At these price levels, the NPV of the project would equal zero. The first situation seems to be the most tolerant to changes in the annual cost savings, although not by much. If the errors were reduced to 5% the project would become a more solid investment. . The price Paperco will pay for the drying equipment totals $2,100,000. By setting the NPV to $0, we know the highest possible price that Paperco will pay before the project becomes uneconomical. Paperco is not willing to pay much more than the asking price for the equipment in any situation, but option one would be ideal for Pressco to maximize their profits.

Year End 1 No Tax Change Corporate Tax Rate Equipment Outlay Installation Cost ITC Net flow PV at 12% Pre Tax Cost Savings A.T Cost Savings PV at 12% Depreciation(new) Depreciation(old) Diff.Depr Diff.in Dep tax Shield PV at 12%

1985 46%

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

-1050 -800 232 -1050 -1618 ($1,444.64) ($2,494.64) 560 302.4 560 302.4 560 302.4 560 302.4 560 302.4 560 302.4 560 302.4 560 302.4 560 302.4 560 302.4

-1050

0 $1,525.56 435 435 200.1 $920.35

739 33 706 324.76

518 32 486 223.56

483 483 222.18

483 483 222.18

242 242 111.32

AT Salvage Value (new) AT Salvage Value (old forgone) Difference PV at 12% AT Salvage Value(old actual) PV at 12% Net NPV

135 32.4 102.6 $29.50 110.9 $99.02 79.78 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

2 New Tax Change & Grandfather 1985 1986 Corporate Tax Rate 34% Annual Cost Saving 560 Annual Inflation rate 0 Equipment Outlay -1050 -1050 Installation Cost -800 ITC 232 Net flow -1050 -1618 PV at 12% ($1,444.64) ($2,494.64) Difference from (1) 0 Pre Tax Cost Savings A.T Cost Savings PV at 12% Difference from 1 Depreciation(new) Depreciation(old) Diff.Depr Diff.in Dep tax Shield PV at 12% Difference from 1 AT Salvage Value (new) AT Salvage Value (old forgone) Difference PV at 12% Difference from 1 AT Salvage Value(old actual) PV at 12% Difference from 1 Net NPV Difference from 1

0 $1,864.57 $339.01 435 435 147.9 $680.26 ($240.09)

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

739 33 706 240.04

518 32 486 165.24

483 483 164.22

483 483 164.22

242 242 82.28

165 39.6 125.4 36.05 6.55 121.1 $108.13 $9.11 $194.37 $114.59

3 New Tax & No Grandfather 1985 1986 Corporate Tax Rate 34% Equipment Outlay -1050 -1050 Installation Cost -800 ITC Net flow -1050 -1850 PV at 12% ($1,651.79) ($2,701.79) Difference from 2 ($207.14) Pre Tax Cost Savings A.T Cost Savings PV at 12% Difference from 2 Depreciation(new) Depreciation(old) Diff.Depr Diff.in Dep tax Shield PV at 12% Difference from 2 AT Salvage Value (new) AT Salvage Value (old forgone) Difference PV at 12% Difference from 2 AT Salvage Value(old actual) PV at 12% Difference from 2 Net NPV Difference from 2

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

0 $1,864.57 $0.00 414 414 140.76 $654.67 ($25.59)

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

560 369.6

710 33 677 230.18

507 32 475 161.5

362 362 123.08

260 260 88.4

259 259 88.06

259 259 88.06

129 129 43.86

165 39.6 125.4 36.05 0 121.1 $108.13 0 ($38.37) ($232.73)

Definition of Problem Ms. Rogers, a marketing representative for Pressco, Inc., spares no effort to persuade its potential customers like Paperco to sign a binding contract of purchasing new mechanical drying equipment. In view of the uncertainty about whether a rumored new tax legislation will come into effect or not, company like Paperco must examine the net present value of the old facility and new purchasing (with ITC earned or not) respectively in order to decide if it's worth investing. In this paper, net present value of new facility under both existing and rumored tax legislation are calculated, as well as the expected cost savings for Paperco. On this basis, I am trying to make some suggestions on the standpoint of Pressco and its counterparts with the help of sensitivity analysis method, and finally our takeaways

Research & Analysis Presso. Inc: a company in the line of mechanical drying equipment Paperco: a potential customer of Pressco. Inc. Jane Rogers: a marketing representative for Pressco In the year 1984, Jane Rogers used to persuade Paperco's management to purchase this new mechanical drying equipment, but it turned out to be unsuccessful because the customer viewed the proposed investment as moderately attractive but easily postponable at little cost to Paperco.In the year 1985, Jane Rogers decided to persuade Paperco's management again with her well-prepared financial presentation, which was designed to help close the sale of the new equipment. In her presentation, she gave the expected price of the new equipment of $2.9 million, and also pointed out that the cost saving that Paperco would realize from the proposed new calculation. Wrap up/Reaffirm Recommendation There are three options Paperco can have in accepting the project: new legislation is passed and they qualify for grandfathering, new legislation is passed and they do not qualify for grandfathering, or no new legislation is enacted. The option three is ruled out as it generates a negative NPV (as per excel calcn.)Between option one & two, I would like to recommend option one as it is the ideal situation in maximizing profits for Pressco.