A B C D E F G H | 5 Lasting Impressions (LI) Company is a medium-sized commercial printer of 6 promotional advertising brochures, booklets, and other direct-mail pieces. The 7 firm's major clients are ad agencies based in New York and Chicago. The typical 8 job is characterized by high quality and production runs of more than 50,000 9 units. Ll has not been able to compete effectively with larger printers because 10 of its existing older, inefficient presses. The firm is currently having problems 11 meeting run length requirements as well as meeting quality standards in a cost- 12 effective manner. 13 14 The general manager has proposed the purchase of one of two large, six-color 15 presses designed for long, high-quality runs. The purchase of a new press would 16 enable LI to reduce its cost of labor and therefore the price to the client, putting the 17 firm in a more competitive position. The key financial characteristics of the old press 18 and of the two proposed presses are summarized as follows: 19 20 21 22 23 24 25 2222222 26 27 28 29 30 31 Old press Originally purchased 3 years ago at an installed cost of $400,00, it is being depreciated under MACRS, using a 5-year recovery period. The old press has a remaining economic life of 5 years. It can be sold today to net $420,000 before taxes; if it is retained, it can be sold to net $150,000 before taxes at the end of 5 years. Press A This highly automated press can be purchased for $830,000 and will require $40,000 in installation costs. It will be depreciated under MACRS, using a 5-year recovery period. At the end of the 5 years, the machine could be sold to net $400,000 before taxes. If this machine is acquired, it is anticipated that the current account changes shown in the following table would result. A B C 31 32 Cash D E F G H | $25,400 33 34 35 36 37 38 39 40 41 Accounts receivable + Inventories Accounts payable + $120,000 $20,000 $35,000 Press B This press is not as sophisticated as press A. It costs $640,000 and requires $20,000 in installation costs. It will be depreciated under MACRS, using a 5-year recovery period. At the end of 5 years, it can be sold to net $330,000 before taxes. Acquisition of this press will have no effect on the firm's net working capital investment. 42 The firm estimates that its earnings before depreciation, interest, and taxes with the old 43 press and with press A or press B for each of the 5 years would be as shown in the table 44 below. The firm is subject to a 40% tax rate, The firm's cost of capital, r, applicable to the 45 proposed replacement is 14%. 46 47 48 Earnings before Depreciation, Interest, and Taxes for Lasting Impressions Company's Presses 49 Year Old press Press A Press B 50 1 $120,000 $250,000 $210,000 51 2 $120,000 $270,000 $210,000 52 3 $120,000 $300,000 $210,000 53 4 $120,000 $330,000 $210,000 54 5 $120,000 $370,000 $210,000 55 56 Press A A B C D E 57 a. 1. Calculation of initial investment for Lasting Impressions Company: 58 59 Installed cost of new press 60 Cost of new press 61 + Installation costs 62 63 64 65 66 67 68 Total cost - new press -After-tax proceeds-sale of old asset Proceeds from sale of old press + Tax on sale of old press Total proceeds-sale of old press + Change in net working capital Initial investment 69 70 F G Press B H A B C D E F G H | 71 a. 2. Depreciation 72 Year Cost Rate 73 Press A 74 1 $870,000 20% 75 2 $870,000 32% 76 3 $870,000 19% 77 4 $870,000 12% 78 5 $870,000 12% 79 6 $870,000 5% 80 Total 81 82 Press B 83 1 $660,000 20% 84 2 $660,000 32% 85 3 $660,000 19% 86 4 $660,000 12% 87 5 $660,000 12% 88 6 $660,000 5% 89 Total 90 91 Existing Press 92 1 $400,000 93 2 $400,000 94 3 $400,000 95 96 97 456 $0 $0 $0 12% 12% 98 99 100 Total Depreciation 0% 0% 0 0 0 A B C D E F G H Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 101 102 Existing Press 103 Earnings before depr., int. and taxes 104 - Depreciation $ 120,000 $ 120,000 $120,000 $120,000 $120,000 $ - $ $ $ $ $ $ 105 Earnings before interest and taxes 106 - Taxes 40% 107 Net operating profits after taxes 108 + Depreciation 109 Operating cash flows 110 111 Press A $ $ $ $ $ $ 112 Earnings before depr., int. and taxes $ 250,000 $ 270,000 $300,000 $330,000 $370,000 $ 113 - Depreciation $ $ $ $ $ $ 114 Earnings before interest and taxes 115 - Taxes 40% 116 Net operating profits after taxes 117 + Depreciation $ $ $ $ $ $ 118 Operating cash flows 119 Old cash flow $ $ $ $ $ $ 120 Incremental cash flow 121 122 123 Press B A B C D 123 Press B 124 Earnings before depr., int. and taxes 125 - Depreciation 126 Earnings before interest and taxes 127 - Taxes 40% 128 Net operating profits after taxes E F G H $210,000 $ 210,000 $210,000 $210,000 $210,000 $ $ $ $ $ $ $ 129 + Depreciation $ $ $ $ $ $ 130 Operating cash flows 131 Old cash flow $ $ $ $ $ - $ 132 Incremental cash flow 133 A B C 134 a. 3. Terminal cash flow 135 136 After-tax proceeds from sale of new press 137 Proceeds from sale of new press 138 Tax on sale of new press 139 Total proceeds - new press 140 141 After-tax proceeds from sale of old press 142 Proceeds on sale of old machine 143 Tax on gain of old press 144 Total proceeds - old press 145 Change in net working capital 146 Terminal Cash Flow 147 148 Press A D E Press B F G H | _C D E F H A B G 149 b. Using the data developed in part a, find and depict on a timeline the relevant cash flow stream associated with each of the two proposed replacement presses, assuming that each isterminated at the end of 5 years. 150 151 152 Cash Flows 153 Year Press A Press B Initial 154 investment $ - $ 155 1 $ $ - 156 2 $ $ 157 3 $ $ - 158 4 $ $ 159 5 $ - $ - 160 161 Insert graph A B D E 162 c. Using the data developed in part b, apply each of the following decision techniques: 163 1. Payback period. 164 Press A: 165 Year Cumulative Cash Flows 166 Press A Press B 167 0 $ $ 168 1 169 2 170 3 171 4 172 5 173 174 Press A 175 Press B 176 177 178 2. Net present value (NPV) 179 Cost of capita 14% 180 Press A Press B 181 Year Cash Flow Year Cash Flow 182 0 0 183 1 1 184 2 2 185 3 3 186 4 4 187 5 5 188 189 Press A 190 Press B 191 F G H A 192 B 193 3. Internal Rate of Return (IRR) 194 Press A 195 C D E F G H | Press B 196 197 d. Draw NVP profiles for the two replacement presses on the same set of axes, and discuss conflicting rankings of the two presses resulting 198 from use of NPV and IRR decision techniques. 199 200 201 Data for NPV Profile NPV 202 Discount rate Press A Press B 203 0% 204 14% 205 0.00% 206 0.00% 207 208 209 210 211 0 0 Insert graph 212 213 214 e. Recommend which, if either, of the presses the firm should acquire if the firm has (1) unlimited funds or (2) captial rationing 215 216 217 218 f. The operating cash inflows associated with press A are characterized as very risky, in contrast to the low-risk operating cash inflows of 219 press B. What impact does that have on your recommendation? 220 221