Pressco Case

Pressco Case

Pressco Case

Apr 30. 2015

• Recommendation

The management of Paperco would have to buy the new drying equipment via binding contracts before rumored tax legislation was passed

• Problem

When was the best situation to replace the old drying equipment of Paperco, Inc that would enable the company to avail greater cost savings?

• Rationale for Decision

The cost saving associated with implementing the new drying equipment was influenced by tax policy, fuel cost, economic outlook, and demand. The management of Paperco had following alternatives with regard to tax policy.

• Alternative1. No change in tax legislation
• Alternative2. Buy the new equipment before rumored tax legislation was passed
• Alternative3. Buy the new equipment after rumored tax legislation was passed

In alternative1, Paperco would continue to use a 5 year ACRS depreciation model with higher depreciation expense, receive the investment tax credit and be subject to 46% tax rate. In alternative2, Paperco would also continue to use a 5 year ACRS depreciation model and receive the investment tax credit, but be subject to 34% tax rate. Finally, in alternative3, Paperco would have to use a 7 year MACRS model with lower depreciation expense. Furthermore, Paperco wouldn’t receive the investment tax credit but would be subject to 34% tax rate. Net Present Value (NPV) of above alternatives was as followings.

Appendix (excel file) contains the detail Net Present Value financial review and incorporates multiple factors including cash flows, investment tax credit, cost saving, tax effect from depreciation and salvage value.

The management of Paperco would choose alternative2 because NPV of alternative2 was greater than other alternatives. In addition, although NPV of alternative1 with no change in tax legislation was less than “0”, the management of Paperco had no choice but to select alternative2 because NPV of alternative3 was less than NPV of alternative1 if rumored tax legislation was passed.

• Discussion and Analysis

Fuel costs are expected to contribute $360,000 of the estimated $560,000 annual cost savings. Accordingly, cost saving in buying the new equipment would be closely correlated to changes in fuel costs over the next decade. Above NPV analysis is based on the assumption that fuel prices remain stable over the next decade. Over the last 10 years until 1985, fuel prices somewhat rose but much of this increase was attributed to the drastic rise in price in 1980 and 1981. If excluding these 2 years, the average increase to fuel prices dropped enough to be meaningless. In the meantime, if gas prices would increase, cost savings would be increasingly favorable and buying the new equipment would be more attractive.