Prints Company is a medium-sized commercial printer of promotional advertising

brochures. The Company is currently having problems cost-effectively meeting run length

requirements as well as meeting quality standards. The general manager has proposed to

replace the current press machine with the purchase of one of two new presses designed

for long-high-quality runs, aiming to put the firm in a more competitive position. The key

financial characteristics of the old press and the two proposed presses are summarised

below:

Old press: Purchased 3 years ago at an installed cost of $ 400,000. It 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 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 the 5 years, the machine could be sold to net $ 400,000 before taxes. If the

2

machine is acquired, it is anticipated that the following current account changes would result to:

Cash : + $ 25,400

Account Receivable : + $ 120,000

Inventories : – $ 20,000

Accounts Payable : + $ 35,000

Press B: It costs $ 640,000 and requires $ 20,000 in installation costs. At the end of the 5 years, the machine could be sold to net $ 330,000 before taxes. No effect is expected on the firm’s net working capital investment.

All presses (old and new) are depreciated under Straight line depreciation.

The general manager estimates that firm’s earnings before depreciation, interest and taxes with the old and the new machines for each of the 5 coming years would be:

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

The firm is subject to a 40% tax rate, the risk-free rate of return is 5.5%, the return in the market portfolio is 12.6% 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 were as follows:

Year

Dividend per share

-1

$ 1.90

-2

$ 1.70

-3

$ 1.55

-4

$ 1.40

-5

$ 1.30

The 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 continue in the future. With the purchase(s), it is expected that the dividend in the coming year will rise to $ 2.15 per share and the annual rate of dividend growth will stand at 13%. Also, because of the higher risk that is associated with the new purchase(s), the required return on the common stock is expected to increase by 2%.

QUESTIONS

a) Evaluate the proposals using the appropriate capital budgeting techniques. Critically discuss the results and the pros and cons of the applied methodologies.

b) Assume that the operating cash flows associated with Press A are characterised as more risky in contrast to those of Press B. Does this fact have any effect on the applied methodologies and subsequently on your recommendations? If yes, how do you propose to handle the issue?

c) Considering that the firm needs to raise capital for the proposed purchase(s), briefly outline the pros and cons of alternative financial instruments and methods that can be used by the firm for the financing of the selected purchase(s). Also, critically discuss the capital structure concept.

d) Based on the valuation of Prints Company common share, estimate the effect that the proposed purchase(s) would have on the firm’s shareholders and explain whether the firm should undertake the investment or not.