Lasting Impressions (LI) Company is a medium-sized commercial printer of promotional advertising brochures, booklets, and other direct-mail pieces. The firm's major clients are ad agencies based in New York and Chicago. The typical job is characterized by high quality and production runs of more than 50,000 units. LI has not been able to compete effectively with larger printers because of its existing older, inefficient presses. The firm is currently having problems meeting run length requirements as well as meeting quality standards in a cost- effective manner. The general manager has proposed the purchase of one of two large, six-color presses designed for long, high-quality runs. The purchase of a new press would enable LI to reduce its cost of labor and therefore the price to the client, putting the firm in a more competitive position. The key financial characteristics of the old press and of the two proposed presses are summarized as follows: 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. Cash + $25,400 Accounts receivable + $120,000 Inventories - $20,000 Accounts payable + $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. The firm estimates that its earnings before depreciation, interest, and taxes with the old press and with press A or press B for each of the 5 years would be as shown in the table below. The firm is subject to a 40% tax rate, The firm's cost of capital, r, applicable to the proposed replacement is 14%. Earnings before Depreciation, Interest, and Taxes for Lasting Impressions Company's Presses Earnings before Depreciation, Interest, and Taxes for Lasting Impressions 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 a. 1. Calculation of initial investment for Lasting Impressions Company: Press A Press B Installed cost of new press Cost of new press 830,000 640,000 + Installation costs 40,000 20,000 Total cost - new press 870,000 660,000 - After-tax proceeds-sale of old asset Proceeds from sale of old press 420,000 420,000 + Tax on sale of old press ???? ???? Total proceeds-sale of old press ???? ???? + Change in net working capital ???? ???? Initial investment ???? ????
Lasting Impressions (LI) Company is a medium-sized commercial printer of promotional advertising brochures, booklets, and other direct-mail pieces. The firm's major clients are ad agencies based in New York and Chicago. The typical job is characterized by high quality and production runs of more than 50,000 units. LI has not been able to compete effectively with larger printers because of its existing older, inefficient presses. The firm is currently having problems meeting run length requirements as well as meeting quality standards in a cost- effective manner.
The general manager has proposed the purchase of one of two large, six-color presses designed for long, high-quality runs. The purchase of a new press would enable LI to reduce its cost of labor and therefore the price to the client, putting the firm in a more competitive position. The key financial characteristics of the old press and of the two proposed presses are summarized as follows:
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.
Cash + $25,400
Accounts receivable + $120,000
Inventories - $20,000
Accounts payable + $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.
The firm estimates that its earnings before depreciation, interest, and taxes with the old press and with press A or press B for each of the 5 years would be as shown in the table below. The firm is subject to a 40% tax rate, The firm's cost of capital, r, applicable to the proposed replacement is 14%.
Earnings before Depreciation, Interest, and Taxes for Lasting Impressions Company's Presses
| Earnings before Depreciation, Interest, and Taxes | |||
| for Lasting Impressions 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 |
a. 1. Calculation of initial investment for Lasting Impressions Company:
Press A Press B
Installed cost of new press
Cost of new press 830,000 640,000 +
Installation costs 40,000 20,000
Total cost - new press 870,000 660,000
- After-tax proceeds-sale of old asset
Proceeds from sale of old press 420,000 420,000
+ Tax on sale of old press ???? ????
Total proceeds-sale of old press ???? ????
+ Change in net working capital ???? ????
Initial investment ???? ????
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