Depreciation and New Equipment

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Point of View

This case study is discussed from Paperco, Inc. point of view of whether they should avail the tax benefits and cost savings in replacing the mechanical drying equipment.

Recommendation

Based on the analysis below in this memo, Paperco should purchase new mechanical drying equipment now in advance in anticipation of the passage of new tax legislation. Purchasing the equipment now maintains a positive Net Present Value for the capital project if the legislation is not enacted, or if the new legislation is enacted and the capital project is contracted early enough so that it is grandfathered in. With tax legislation grandfathered, the project gets the benefit of the new lower corporate tax rate and the old ACRS
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Paperco would retain all tax credits due to the fact the machine has been in service for 84 months, and use a 5-year ACRS depreciation model for the new equipment. This option has a positive NPV of $2,619,745.
Option II in which the new tax proposal is enacted. The new equipment is installed in December 1986. Paperco signs a binding contract soon enough to be “grandfathered”, this allows Paperco to receive the 8% tax credit and use ACRS depreciation. At the same time, their tax rate would fall to 34%. Paperco would benefit from this more favorable “grandfathered” tax approach. Option II has a positive NPV of $3,414,104.
Option III in which the new tax proposal is enacted and Paperco installs the new equipment in December 1986, but they do not sign a binding contract in time to be “grandfathered” and receive the 8% investment tax credit and use ACRS depreciation. The company will use MACRS and a depreciation period of 7 years. The NPV of the project with this timing and structure is $3,228,044. Without the “grandfathered” tax allowance, the new tax legislation makes the project unattractive based on lower Net Present Value.

Calculations

Re-affirmation

There are three options available to Paperco, Inc. with respect to this capital investment:
Option I: New legislation is passed and Paperco

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