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...
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