1 Introduction

In 1985, Pressco, Inc intends to sell its mechanical drying equipment to Paperco, Inc at a price of $2.9
million. The new equipment will function from 1987 and will bring Paperco, Inc $560,000 cost savings
per year. Considering new tax legislation to be taken, this replacement can be an investment opportunity
for Paperco, Inc.

2 Recommendation
After conducting solid replacement analysis, we recommend:
1. Paperco should process the installation of new equipment as it would be a beneficial project with
positive net present value ($194,365) under three possible tax legislation scenarios.
2. Paperco should also sign a binding purchases contract with us as soon as possible given that there
are +10% estimation error of cost savings.

3 Weighted average cost of capital calculation

Given 34% tax rate, we derived cost of debt and cost of equity respectively to calculate weighted average
cost of capital.
For cost of debt, we recommend Marriott Corporation to take debt rate premium of whole company,
which is 1.30% in this case, with 30-year maturity fixed government interest rates, which is 8.95%, to
acquire cost of debt. There are two reasons for doing this.
First of all, we aim to calculate WACC based on the entire entity in this stage, meaning that taking debt
rate premium of whole company is more suitable than using weighted average debt rate premium of three
subdivisions. It is especially true here because we do not exactly know what weight to use.

Secondly, Marriott Corporation is a company with long history. For a company with three relative longterm lines of business, among which lodging is the dominate one (51% profit), and having been in
business for more than 60 years, we believe that it is reasonable to choose 30-years government interest
rate for it instead of short terms ones.
For cost of equity, we utilized capital asset pricing model on the following procedure.
To begin with, we suggest the company to use average long-term U.S. government bond returns (19261987) as risk-free rate. There are, also, two reasons. First of all, using long-term average could affectively
avoid the influence of short- term economic fluctuations, such as inflation and fuel costs change.
Secondly, as a rule of thumb, long-term project should employ risk free rate which matches up with cash
flow duration.

In scenario 1, we assumed that old tax law would still be applied, with tax rate and investment tax credit
unchanged for the following eleven years (1986-1996). The initial investment outlay, which is half of the
equipment cost, happened on 1985. One year later, another 50% along with the installation cost were
going to be paid as outflow, hugely influencing net cash flows of the current year. So did proceeds from
selling old equipment (cash inflow). Given that market value of the old equipment is much larger than its
remaining book value ($33,000+$32,000 in this case), the selling incurs a tax-adjusted benefit by
applying the equation Selling Price=Market Price-Tax %( Remaining Book Value). Meanwhile,
investment tax credit and new equipments depreciation brought us positive cash flows in either direct
form (tax credit ) or indirect form (tax saving from depreciation). Summing all these cash flows up, we
derived net cash flow of 1986. Afterwards, we have constant cost savings for following ten years as well
as depreciation increase for next two years. While marginal corporation tax is deducted from cost saving,
tax savings from depreciation are calculated. Adding after-tax cost savings with tax savings, we obtained
net operating cash flow from 1987 to 1996. For year 1996, salvage values of two equipment needed to be

calculated as terminal value. We believe that if the old machine was expected to have a positive salvage
value at the end of ve years, replacing the old machine now would eliminate this cash ow. Thus, the
after-tax salvage value of the old machine would represent an opportunity cost to the rm, and it would be
included as a cash outow in the terminal cash ow section of the worksheet. After applying Terminal
Value=(1-Tc)*salvage value difference to acquire terminal value, we summed it with after-tax cost
savings to get net cash flows for 10 years.
The final net present value of the project is $79,781.74, which is a so called moderate attractive number.
In scenario 2, we assumed that new laws legislation enacted and Paperco signed a binding purchase
contract soon enough thus it could take the 8% investment tax credit and the use of ACRS depreciation.
Therefore previous assumptions still held in this scenario except for that tax rate changes from 46% to
34%. By repeating the calculation process with new tax rate, we obtained a $194,365.03 net present value
this time, more than two times larger than net present value in scenarios 1.
In the last scenario, new tax law is assumes to be enacted. Meanwhile, no binding purchase contract was
expected to exist between two parities, meaning that investment tax credit no longer apply. While tax rate
remains to be 34%, depreciation period became longer and its values changed too.
After making these adjustment, we calculated net present value in the scenario to be -$38,366.22,
indicating no benefit of the project for Paperco.
Additionally, we went through a sensitivity analysis of net present value to cost savings. As there could be
a +10% estimation error on cost savings, value of cost saving may largely influence projects net present
value. Therefore, according to function solver in Excel, we acquired break-even points of cost savings
when net present value is 0 for all scenarios. The outcomes are $530,714, $501,625 and $571,523
respectively. The range of cost saving is between 504,000 and 616,000 and the breakeven point in
Scenario 2 is $501625, which is not in the estimation interval, implicating that under no circumstances

will Scenario 2 reach a negative present value. Therefore, Paperco should sign a binding purchase
contract before the enact of new tax law legislation to maximum its benefit.
The exact net present value calculating procedures and result are showed in the Appendix.

4 ADDITIONAL CONCERNS
Our analytical results can be vulnerable due to fluctuating estimation of cost savings. In addition to
engineering errors, there are many factors influencing cost savings calculation, such as changing fuel
costs and inflation rates. Thus the outcome can be more reliable if a smaller estimation error range of cost
savings is offered.

5 SUMMARY
Both replacement analysis and sensitivity analysis provide solid evidence showing that it is in Paperco,
Incs best interest to undergo replacement project and sign up the binding contracts. As the law is going to
be enacted, this purchase would end up being a $194,365.03 net present value project regardless of
estimation error, incurring added benefit of increasing the scalability of Papercos existing infrastructure
and boosting future development.

APPENDIX
Exhibit 1. Three scenario analysis results

Scenario

Tax rate

ITC

Depreciation period

NET
PRESEN
T VALUE

46%

8%

ACR

$79,782

34%

8%

ACR

$194,365

34%

none

MACR

-$38,366

Exhibit 2. Net Present Value in three scenarios

3
Scenario

NPV

1
-100000

100000

200000

300000

Exhibit 3. Break-even points of sensitivity analysis

700000
600000
500000
400000
300000
200000
100000
0
1

The red bar indicates the lowest margin of values of cost savings, the blue bar indicates highest margin of
values of cost savings and orange bars go for break-even points in different scenarios.
Only point of scenario 2 is out of the range.
Exhibit 4. Replacement analysis

Scenario 1

Scenario 2

Scenario 3