I: Statement of Financial Problem:
In November 1985 Paperco was presented with the critical concern determination of replacing its bing mechanical drying equipment that had been originally placed into service in 1979 with more efficient equipment provided by Pressco. Inc. The effects of this determination would hold far making effects as replacing the equipment could ensue in cost nest eggs up to $ 560. 000 yearly. However. there were other critical factors to turn to before traveling frontward with the undertaking.
One of the most of import factors to see was the rumored new revenue enhancement statute law that would. “ ( 1 ) extinguish the investing revenue enhancement recognition for new equipment ; ( 2 ) extend depreciation lives for new equipment ; and ( 3 ) cut down the corporate revenue enhancement rate from 46 % to 34 % beginning in 1986. ( Harvard. 1991 ) ” Therefore. the fiscal job facing Paperco is what is the Net Present Value ( NPV ) of replacing its bing mechanical drying equipment with the more efficient equipment from Pressco. presuming ( 1 ) the rumored revenue enhancement statute law is enacted ; ( 2 ) Paperco fails to subscribe the contract in clip to have the investing revenue enhancement recognition ; and ( 3 ) the equipment is installed in December 1986. Two: General Framework for Financial Analysis:
“Net Present Value ( NPV ) is a method of ranking investing proposals utilizing the NPV. which is equal to the present value of the project’s free hard currency flows discounted at the cost of capital. ( Brigham. 2009 ) ” Simply stated the NPV of a proposed undertaking allows organisations to find whether or non the undertaking is deserving prosecuting. It shows how much the undertaking will lend to stockholder wealth ( Brigham. 2009 ) . NPV is the best fiscal measuring tool organisations can use in finding the possible value a undertaking may add to the organisation. By and large talking. the higher the NPV. the more desirable the undertaking. Conversely. a lower NPV or negative NPV should be viewed as a warning mark and the undertaking should be rejected. The most ambitious issue that arises when organisations use NPV as a method of choosing or rejecting undertakings. is accurately estimating future hard currency flows. One of the grounds this can be hard prevarications in the possible complexness of a proposed undertaking. Possible accommodations that may necessitate to be made in order to accurately gauge future hard currency flows are ( 1 ) depreciation ; ( 2 ) revenue enhancements ( this includes revenue enhancement inducements and altering revenue enhancement Torahs ) ; and ( 3 ) salvage values. By seting for these possible factors. future hard currency flows can be more accurately estimated and undertakings true NPV can be determined.
The undermentioned stairss should be taken in ciphering a project’s NPV – The NPV equation is illustrated in Exhibit 1 – pg 371 ( Brigham. 2009 ) : 1. “The present value of each hard currency flow is calculated and discounted at the project’s risk-adjusted cost of capital ( or WACC ) . R = ( ___ ) % . 2. The amount of the discounted hard currency flows is defined as the project’s NPV. ” Something else to see is utilizing NPV to compare more than one undertaking. There are two types of undertakings ( 1 ) “Independent undertakings – undertakings whose hard currency flows are non affected by one another ; ( 2 ) reciprocally sole undertakings – undertakings where if one undertaking is accepted. the other must be rejected ( Brigham. 2009 ) . ” When measuring independent undertakings. the undertaking should be accepted so long as the NPV is greater than nothing. With reciprocally sole undertakings. the undertaking with the higher NPV should be accepted so long as it is positive. As with any method. concerns must besides see both concern and fiscal hazard when measuring the value proposed undertakings may supply to the organisation. Will the execution of the undertaking be immune from hazards such as rising prices. competition. or a fighting economic system? Questions such as this must be brought up. discussed. and evaluated before any undertaking is selected for execution. III. Application of the Financial Model:
As Paperco calculates the NPV of replacing its bing mechanical drying equipment with the more efficient equipment from Pressco. presuming ( 1 ) the rumored revenue enhancement statute law is enacted ; ( 2 ) Paperco fails to subscribe the contract in clip to have the investing revenue enhancement recognition ; and ( 3 ) the equipment is installed in December 1986 ; it must turn to the deductions from the undermentioned activities / events illustrated in Exhibit 2: 1. Cash Escapes:
* As stated in the premises. the equipment payment footings are as follows: 50 % ( $ 1. 050. 000 ) with order. December 1985 ; 50 % ( $ 1. 050. 000 ) upon start-up of installation. December 1986. Therefore we must account for those two minutess as hard currency escapes in old ages 1985 and 1986. Additionally. there is an $ 800. 000 installing cost that will happen during December 1986. which must besides be accounted for as a hard currency escape in 1986. 2. Cash Inflows:
* Tax shelter from depreciation of bing ( old ) equipment: I. In 1985 the hard currency influx caused by the revenue enhancement shelter from depreciation will be calculated utilizing the bing 46 % rate. In 1986 that revenue enhancement rate will be reduced to 34 % and the equipment will be sold that twelvemonth so hard currency influxs from the old equipment will end that same twelvemonth. * Tax shelter from depreciation of new equipment:
two. Since the new equipment will be installed in 1986. the new revenue enhancement rate of 34 % will be used to cipher hard currency influxs from the revenue enhancement shelter from depreciation of the new equipment. This will go on through the allowed depreciation period of 7 old ages ( 1993 ) harmonizing to the Modified Accelerated Cost Recovery System ( MACRS ) . * After revenue enhancement impact of cost nest eggs:
three. The one-year cost nest eggs from the installing of the new equipment are estimated to be $ 560. 000. In order to cipher the revenue enhancement impact of cost nest eggs we utilize a rate of 66 % ( 100 % – 34 % revenue enhancement rate ) and multiply that by the $ 560. 000. May it be noted that these nest eggs will non get down happening until the equipment has been in usage for an full twelvemonth and the old equipment is no longer being used ( 1986 ) .
* Returns from equipment disposal after revenue enhancements:
four. In 1986 the bing equipment will be sold. which will hold an estimated market value of $ 150. 000 ( Postpone A ) . This hard currency influx will hold a positive consequence on net hard currency flow for 1986. v. In 1996 the new equipment will be sold. which will hold an estimated salvage value at the terminal of its utile life of $ 250. 000 ( Table B ) . This hard currency influx will besides hold a positive consequence on net hard currency flow for 1996. Calculation of NPV based on hard currency influxs and escapes:
In order to cipher the NPV for the undertaking the amount of the net hard currency flows for each twelvemonth must be calculated and multiplied by the present value factor ( Table C ) for the given hard currency flow twelvemonth at 12 % . May it be noted that 1985 is considered twelvemonth 0 and will hold a present value factor of 1. Once each old ages NPV has been calculated. the amount of each year’s NPV is calculated to give us the entire NPV for the undertaking. which in this instance is equal to $ 95. 680. Since the NPV of the undertaking is greater than zero the undertaking should be accepted. IV. Premises and Special / Mitigating Fortunes:
* Equipment cost: $ 2. 100. 000.
* The decrease in the corporate revenue enhancement rate from 46 % to 34 % . * The usage of the Modified Accelerated Cost Recovery System ( MACRS ) in accounting for depreciation. * Start-up of installation: December 1986. 12 months after reception of order. which was anticipated in December 1985. * The riddance of the investing revenue enhancement recognition for new equipment. * Equipment payment footings: 50 % ( $ 1. 050. 000 ) with order. December 1985 ; 50 % ( $ 1. 050. 000 ) upon start-up of installation. 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 installation ( after start-up ) : 10 old ages. V. Conclusions and Recommendations:
In decision. the Net Present Value ( NPV ) of replacing Paperco’s bing mechanical drying equipment with the more efficient equipment from Pressco. presuming ( 1 ) the rumored revenue enhancement statute law is enacted ; ( 2 ) Paperco fails to subscribe the contract in clip to have the investing revenue enhancement recognition ; and ( 3 ) the equipment is installed in December 1986 is $ 95. 680. Since the proposed project’s NPV is greater than nothing. the undertaking should be accepted. Even with the assurance provided by a positive NPV. Paperco must see possible concern and fiscal hazards that may ensue due to accepting the undertaking and traveling frontward. As mentioned in the instance. direction was peculiarly concerned that the rumored revenue enhancement statute law may hold a negative consequence on gross revenues. This concern every bit good as any others must be identified and discussed before traveling frontward on the project’s positive NPV entirely.