Question

The general manager of Design Impression Company has proposed the purchase of one of two large six-colour presses designed for long, high-quality runs. The purchase of a new press would enable the firm to reduce its cost of labour and therefore the price to the clients, putting the firm in a more competitive position. The key financial characteristics of the existing press and the two prosed presses are summarised below. Old press: Originally purchased three years ago at an installed cost of $400,000, it is being depreciated using a straight-line method over a 10-year effective life. The old press has a remaining economic life of five years. It can be sold today to net $460,000 before taxes. If the old press is retained, it can be sold to net $150,000 before taxes at the end of five years. Press A: This highly automated press can be purchased for $830,000 plus $40,000 in installation costs. It will be depreciated using the straight-line method over a five-year effective life. At the end of the five years, the machine could be sold to net $400,000 before taxes. Press B: This press is not as sophisticated as press A. It costs $640,000 plus $20,000 in installation costs. It will be depreciated using the straight-line method over a five-year effective life. At the end of five years, it can be sold to net $330,000 before taxes. The firm estimates that its earnings before depreciation and taxes with the old press and with press A or press B for each of the five years will be as show in the table. Assume the firm is subject to a 30% tax rate on ordinary income and NZ tax rule applies on capital gain (capital gain is not taxed). The firm’s cost of capital applicable to the proposed replacement is 14%. Profit before depreciation and taxes for Design Impression Company’s presses Year Old press Press A Press B 1 $120,000 $250,000 $210,000 2 120,000 270,000 210,000 3 120,000 300,000 210,000 4 120,000 330,000 210,000 5 120,000 370,000 210,000 Recommend which, if either, of the presses the firm should acquire. You can write answer and reason directly on Excel spreadsheet.

Answer 1

In these types of questions, it is always advised to create a table like I did (attached below). As per the data given by you the greatest NPV generating Press A should be acquired.

Step by step approach mentioned below.

	Tax	30.00%
	WACC	14.00%
YEAR	Old press PBDT	Dep	PBT	Tax	PAT	CF	PVF	PV
0		0						-460000
1	120000	-62000	58000	-17400	40600	102600	0.877192982	90000
2	120000	-62000	58000	-17400	40600	102600	0.769467528	78947
3	120000	-62000	58000	-17400	40600	102600	0.674971516	69252
4	120000	-62000	58000	-17400	40600	102600	0.592080277	60747
5	120000	-62000	58000	-17400	40600	102600	0.519368664	203287
							NPV Old press	42234
YEAR	Press A PBDT	Dep	PBT	Tax	PAT	CF	PVF	PV
0	0	0						-870000
1	250000	-94000	156000	-46800	109200	203200	0.877192982	178246
2	270000	-94000	176000	-52800	123200	217200	0.769467528	167128
3	300000	-94000	206000	-61800	144200	238200	0.674971516	160778
4	330000	-94000	236000	-70800	165200	259200	0.592080277	153467
5	370000	-94000	276000	-82800	193200	287200	0.519368664	549163
							NPV Press A	338782
YEAR	Press B PBDT	Dep	PBT	Tax	PAT	CF	PVF	PV
0	0	0						-660000
1	210000	-66000	144000	-43200	100800	166800	0.877192982	146316
2	210000	-66000	144000	-43200	100800	166800	0.769467528	128347
3	210000	-66000	144000	-43200	100800	166800	0.674971516	112585
4	210000	-66000	144000	-43200	100800	166800	0.592080277	98759
5	210000	-66000	144000	-43200	100800	166800	0.519368664	416631
							NPV Press B	242638