Depreciation and New Equipment

Topics: Depreciation, Investment, Taxation in the United States Pages: 7 (1024 words) Published: April 30, 2014
Point of View

This case study is discussed from Paperco, Inc. point of view of whether they should avail the tax benefits and cost savings in replacing the mechanical drying equipment.

Recommendation

Based on the analysis below in this memo, Paperco should purchase new mechanical drying equipment now in advance in anticipation of the passage of new tax legislation. Purchasing the equipment now maintains a positive Net Present Value for the capital project if the legislation is not enacted, or if the new legislation is enacted and the capital project is contracted early enough so that it is grandfathered in. With tax legislation grandfathered, the project gets the benefit of the new lower corporate tax rate and the old ACRS depreciation method. Although when presented with this project one year ago in 1984, Paperco was able to be postponed this capital project since it was merely “moderately attractive”. The prospect of new tax legislation being enacted as rumored makes the Net Present Value of the project comparatively more positive if the tax law changes are enacted, so Paperco should act now before tax law changes make this project infeasible.

Background

In November 1985, Jane Rogers a marketing representative of Pressco, Inc. approached Paperco, Inc. to sell its mechanical drying equipment at a price of $2.9 million. This new equipment would replace less efficient facilities that had been placed in service late in December 1979. According to Roger, the total cost saving (exclusive of depreciation charges) from the proposed installation of new equipment amounted to $560,000 per year. Of this amount, $360,000 in savings was expected to come from more efficient fuel utilization.

One year earlier, Rogers had been unsuccessful in interesting Paperco’s management in purchase of new equipment. Paperco felt that the investment in new equipment as moderately attractive at that time. However, beginning 1986, new tax legislation had been rumored to: (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%.

Paperco’s senior management was concerned that the basic thrust in the firm’s sales of mechanical drying equipment. Paperco’s management suddenly expressed significant interest in moving forward with the purchase of new equipment and seemed anxious to sign a binding contract.

Discussion and Analysis

We need to analyze when is the best situation for Paperco, Inc. to replace the old facilities with new drying equipment that will enable the Company to avail greater tax benefits and cost savings.

There are three alternative courses of action available to Paperco, Inc. to decide whether to buy the new drying equipment or not.

I. Buy the new equipment yet no legislation is enacted
Advantages
Continue to use a 5 years ACRS depreciation model with higher depreciation expense Efficiency in operations due to new equipment

Disadvantages
Retain all tax credits due to using 5 year ACRS depreciation model in equipment with useful life of 7 years Tax rate continued at 46%

II. Buy the new equipment when the new tax proposal is enacted and bind the contract soon enough to be grandfathered or before the enactment of the law Advantages
Continue to use a 5 years ACRS depreciation model with higher depreciation expense Efficiency in operations due to new equipment
Investment tax credit that will reduce Paperco’s taxes
Tax rate reduced to 34% from 46%

Disadvantages
Depreciation life of the equipment will not be extended

III. Buy the new equipment when the new proposed tax is enacted but do not bind the contract in time to be grandfathered or after the enactment of the law Advantages
Efficiency in operations due to new equipment
Tax rate reduced to 34% from 46%
Depreciation life of the equipment will be extended by 2 years

Disadvantages
MACRS depreciation model will generate lower...
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