Question

The CSI Corporation is looking to replace an existing printing press with one of two newer models that are more efficient. The current press is three years old, cost 32,000 and is being depreciated under MACRS using a 5-year recovery period. The first alternative under consideration, Printing Press A, cost $40,000 to purchase and $8,000 to install. It has a 5 year usable life and will be depreciated under MACRS using a 5-year recovery period. The second alternative, press B cost $54,000 to purchase and $6,000 to install. It also has a 5 year usable life and will be depreciated under MACRS using a 5 year recovery period. The purchase of press A would result in a $4,000 increase in net working capital, and the purchase of Press B would increase net working capital by $6,000. The projected Earnings before depreciation interest and taxes for each alternative is presented below.

Year	Press A	Press B	Existing press
1	25,000	22,000	14,000
2	25,000	24,000	14,000
3	25,000	26,000	14,000
4	25,000	28,000	14,000
5	25,000	28,000	14,000

The existing press can currently be sold for $18,000 before taxes. At the end of the 5 years the existing press can be sold for $1,000 before taxes. Press A can be sold to net $12,000 before taxes and press B can be sold to net $20,000 before taxes at the end of the 5 year period. The firm is subject to a 40% tax rate.

The company has $100M of debt outstanding with a yield-to-maturity of 8%, and has $150M of equity outstanding with a beta of 0.9. The expected market return is 13% and the risk-free rate is 5%.

Which press is the best option? And why?

Answer 1

		DEPRECIATION OF OLD EXISTING PRESS
		Cost of old existing press	$32,000
		Year (From the date of installation)	1	2	3	4	5	6
	A	MACRS 5 yearDepreciation Rate	20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
	B=A*320000	Annual Depreciation	$6,400	$10,240	$6,144	$3,686	$3,686	$1,843
	C	Accumulated Depreciation	$6,400	$16,640	$22,784	$26,470	$30,157	$32,000
	D=32000-C	Book Value of old Press	$25,600	$15,360	$9,216	$5,530	$1,843	$0
		Book Value of existing Press now (Year3)	$9,216
		Salvage value of old press now	$18,000
		Gain on salvage	$8,784	(18000-9216)
		Tax on gain =8784*40%	$3,514
		After tax Cash flow on salvage of existing press now	$14,486	(18000-3514)
		After tax salvage value at the end of 5 years from today	$600	1000*(1-0.4)
		ANALYSIS OF REPLACEMENT BY PRESS A
		Initial Investment:
		Cost of new Press	$40,000
		installation cost	$8,000
	a	Total Depreciable asset	$48,000
	b	Increase in net working Capital:	$4,000
	c	Net Salvage cashflow from old press now	$14,486
	d=a+b-c	Initial Investment	$37,514
		DEPRECIATION OF NEW PRESS A
		Year(from today)	1	2	3	4	5	6
	A	Depreciation of OLD PRESS	$3,686	$3,686	$1,843	$0	$0	$0
	B	Depreciation Rate	20.00%	32.00%	19.20%	11.52%	11.52%	5.76%
	C=B*$48000	Depreciation amount	$9,600	$15,360	$9,216	$5,530	$5,530	$2,765
	D=C-A	Incremental   annual depreciation expense	$5,914	$11,674	$7,373	$5,530	$5,530
		Salvage Value of new Press A(Before Tax)	$12,000
		Book Value at end of year5	$2,765
		Gain on Salvage	$9,235	(12000-2765)
		Tax on Gain =9235*40%	$3,694
		After tax Salvage cash flow=12000-3694	$8,306
		Salvage Value of old existing at end of 5 years	$600
		Incremental Salvage cash flow	$7,706	(8306-600)