Your task as a Financial Analyst is to prepare a project evaluation report to Executive Committee of

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Question:

Your task as a Financial Analyst is to prepare a project evaluation report to Executive Committee of XYZ Company indicating whether the firm should invest in Press A or Press B. Your report should include the answers to the following Questions 1 to 4. It is important to list your assumptions in applying the project evaluation methods and show clearly the workings in deriving your results.

QUESTIONS

1. Prepare a cash flow table (which incorporates taxes and includes initial investment, operating and terminal cash flows) using the information given in the case. The incremental cash flows are to be prepared for: (a) Press A versus Old Press and (b) Press B versus Old Press. Compute NPV and IRR for the proposed project. Based on each method of investment evaluation, would you accept or reject the project?

2. Undertake research to identify the qualitative factors (i.e., factors which are unquantifiable at present) that would affect the accept/reject decision of the project?

3. It is necessary to check if the project made financial sense before it is accepted. Based on the cash flow table derived in Question 1, conduct a sensitivity analysis of NPVs to change in annual earnings of Press A, annual earnings of Press B, and applicable discount rate individually. Assume each of these variables can deviate from its estimated value by plus or minus 15%. [Hint: Provide the answers to this question even if your decision is to reject the project.]

4. Consider all information given in the case study and the results derived in Questions 1 to 3.

Advise the executive committee on whether they should invest in Press A or Press B. Discuss the reasons for your recommendation and the issues the XYZ Company needs to consider given this advice.

XYZ Printing Company is a commercial printer of promotional advertising brochures and booklets. The job is typically characterised by production runs of more than 80,000 units. XYZ has not been able to compete effectively with larger printers because of its existing older inefficient presses. The general manager has proposed the purchase of one of two large presses designed for long, high-quality runs. The purchase of a new press would enable XYZ to reduce its cost of labour and therefore the price to the client, putting the firm into a more competitive position. The key financial characteristics of the old press and the two proposed presses are summarised as below:

Old Press: Originally purchased 3 years ago at an installed cost of $400,000, it is being depreciated at 20% on a reducing balance basis. The old press has a remaining life of 5 years. It can be sold today to net $300,000 before taxes.

Press A: This highly automated press can be purchased for $830,000 and will require $40,000 in installation costs. It will be depreciated at 30% on a reducing balance basis. At the end of 5 years, the machine can be sold for a net of $400,000 before taxes. If this machine is acquired, it is anticipated that the working capital requirement would be $130,000.

Press B: This press is not as sophisticated as Press A. This is a semi-automatic press that costs $640,000 and requires $20,000 in installation costs. It will be depreciated at 30% on a reducing balance basis. At the end of 5 years, it can be sold for a net of $330,000 before taxes. Acquisition of this press will have no effect on the firm’s net working capital investment. XYZ Printing Company has already spent $12,000 for the feasibility study of the new project.

The new machines are quite large. If the proposed project goes ahead, XYZ Company will have to use its existing excess warehouse facility to install the new machine. The excess existing warehouse facility has been currently rented to another company at an annual rent of $15,000. The firm has estimated the earnings before depreciation, interest, and taxes with the old press, press A, and press B for each of the next 5 years (shown in Table 1).

Table 1: Earnings before depreciation, interest and taxes

Year	Old Press	Press A	Press B
1	$120,000	$300,000	$210,000
2	$120,000	$300,000	$210,000
3	$120,000	$300,000	$210,000
4	$120,000	$300,000	$210,000
5	$120,000	$300,000	$210,000

The CEO of XYZ Printing Company firmly believes that the firm should invest in capital assets now to ensure that they can compete with other firms in terms of pricing and quality. The director of marketing also believes that the company should invest in the latest technology and machinery to maintain the market share, otherwise “we are going to be bypassed”. On the other hand, the director of finance, who is well aware of the possible financial repercussions of committing a huge amount of capital in new technology and machinery, insists that the new machinery, if purchased, should generate positive net cash flows and increase the value of the company. “Otherwise, the shareholders would not be happy”. The manager is also concerned about the key environmental issues associated with the fully automatic press. The new machine releases volatile organic compounds into the atmosphere causing air pollution. The semi-automatic press is considered to be environmentally friendly and consumes less energy relative to fully-automated press.

The appropriate, after-tax, cost of capital (discount rate) for the project is considered to be 12%. This is the same as the firm’s after-tax weighted average cost of capital. Assume that the company is subject to 30% corporate tax and that the tax is paid at the end of the same year (i.e., not the following year).