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Prints Company is a medium-sized commercial printer of promotional advertising brochures.
Prints Company is a medium-sized commercial printer of promotional advertising brochures. The Companyis currently having problems cost-effectively meeting run length requirements as well as meeting qualitystandards. The general manager has proposed to replace the current press machine with the purchase ofone of two new presses designed for long-high-quality runs, aiming to put the firm in a more competitiveposition. The key financial characteristics of the old press and the two proposed presses are summarisedbelow:Old press: Purchased 3 years ago at an installed cost of $ 400,000. It has a remaining economic life of 5years. It can be sold today to net $ 420,000 before taxes. If it is retained, it can be sold to net $ 150,000before taxes in at the end of 5 years.Press A: It can be purchased for $ 830,000, and will require $ 40,000 in installation costs. At the end of the5 years, the machine could be sold to net $ 400,000 before taxes. If the machine is acquired, it is anticipatedthat the following current account changes would result to:Cash : + $ 25,400Account Receivable: + $ 120,000Inventories : - $ 20,000Accounts Payable : + $ 35,000Press B: It costs $ 640,000 and requires $ 20,000 in installation costs. At the end of the 5 years, themachine could be sold to net $ 330,000 before taxes. No effect is expected on the firm’s net working capitalinvestment.All presses (old and new) are depreciated under a Modified Accelerated Cost Recovery System (MACRS)using a 5 year recovery period. The depreciation rates for each year are:Year Rate1 0.202 0.323 0.194 0.125 0.126 0.05The general manager estimates that firm’s earnings before depreciation, interest and taxes with the old andthe new machines for each of the 5 coming years would be:Year Old press Press A Press B1 $ 120,000 $ 250,000 $ 210,0002 $ 120,000 $ 270,000 $ 210,0003 $ 120,000 $ 300,000 $ 210,0004 $ 120,000 $ 330,000 $ 210,0005 $ 120,000 $ 370,000 $ 210,000The firm is subject to a 40% tax rate, the risk-free rate of return is 5.5%, the return in the market portfolio is12.6% and the beta coefficient for the company is 1.2.Finally, assume that the immediate past 5 years the annual dividends paid on the firm’s common stock wereas follows:Year Dividend per share-1 $ 1.90-2 $ 1.70-3 $ 1.55-4 $ 1.40-5 $ 1.30The general manager expects that without the proposed purchase(s), the dividend in the coming year will be$ 2.09 per share and the historical annual rate of growth (rounded to the nearest whole percent) will continuein the future. With the purchase(s), it is expected that the dividend in the coming year will rise to $ 2.15 pershare and the annual rate of dividend growth will stand at 13%. Also, because of the higher risk that isassociated with the new purchase(s), the required return on the common stock is expected to increase by2%.QUESTIONSa) Determine the necessary values that will help you to evaluate the proposal made by the generalmanager. (Note that due to MACRS depreciation, for the operating cash flows calculations be sureto consider the depreciation in year 6. Also, the terminal value is at the end of year 5. Seesuggested textbook for details on these issues).b) Using the data from part (a) evaluate the proposals using the appropriate capital budgetingtechniques. Critically discuss the results and the pros and cons of the applied methodologies.Explain if your recommendations change if the firm operates under capital rationing.c) Assume that the operating cash flows associated with Press A are characterised as more risky incontrast to those of Press B. Does this fact have any effect on the applied methodologies andsubsequently on your recommendations? If yes, how do you propose to handle the issue?d) Considering that the firm needs to raise capital for the proposed purchase(s), briefly outline the prosand cons of alternative financial instruments and methods that can be used by the firm for thefinancing of the selected purchase(s).e) Based on the valuation of Prints Company common share, estimate the effect that the proposedpurchase(s) would have on the firm’s shareholders and explain whether the firm should undertakethe investment or not.
