MEMO TO: FROM: SUBJECT: DATE: CC: JOHN SMITH, CFO TOBY ODENHEIM PRESSCO EQUIPMENT PURCHASE NOVEMBER

30, 1985

Executive Summary
I recommend proceeding with the Pressco equipment upgrade as it yields a substantial efficiency-based cost savings under two of the three likely tax legislation scenarios (see Figure 1), even when holding fuel prices and output levels constant. There is relatively little downside risk, as the financial loss under the least favorable legislation is comparatively small. Figure 1: Purchase Cost and NPV under Different Tax Scenarios Scenario
Scenario 1: No Change in Tax Legislation Scenario 2: New Tax Rate, Grandfathered Depreciation and Tax Credit Scenario 3: New Tax Rate, No Investment Tax Credit, 7-year Depreciation

Purchase Cost after Tax Credit (000s)

$2,500 $2,500

Net Present Value, 12% (000s)

$79 $194

$2,700

($38)

While conservative estimates were used in the modeling, the economic outlook is favorable, which is expected to further boost return on investment by 8% per year. Fuel cost increases are forecast to be flat to modest (0% to 2%) on average over the next decade, and market demand is expected to grow year-over-year. New drying equipment also better positions Paperco for higher output levels, expected due to both increased annual consumption per person and overall growth in population. The purchase has the added benefit of increasing the scalability of our existing infrastructure, though additional PP&E investments would still be needed to boost total output, in addition to providing expected cost saving.

Discussion and Analysis

The cost saving associated with implementing the new drying equipment is influenced by tax policy, fuel cost, economic outlook, and demand, each of which outlined below, followed by a summary recommendation. Appendix 1 contains the detail Net Present Value financial review and incorporates multiple factors including cash flows, tax credit and policy assessments, cost saving, salvage value and depreciation. Tax Legislation With the current legislation under consideration in congress three scenarios are considered likely: Scenario 1: Legislation not enacted and status quo remains Scenario 2: Legislation is enacted but existing purchases are grandfathered Scenario 3: Legislation is enacted, Tax Credit is terminated and less favorable 7-year depreciation is mandated NPV analysis has been conducted for each scenario, based on a 12% cost of capital. All calculations are shown in detail in the appendix and summarized, in Figure 1, above. Figure 2 calculates that expected saving obtained by multiplying the NPV from each scenario by the estimated probability of the occurrence, to arrive at an expected saving of $113,000, with both fuel price and demand held constant based on current state.. Figure 2: Expected Savings (000s) based on predicted likelihood of tax scenarios
Legislation Scenario 1 Scenario 2 Scenario 3 NVP Probability NPV*Probability $79 30% $24 $194 50% $97 ($38) 20% ($8) Expected Savings $113

Fuel Costs and Inflation Fuel costs are expected to contribute $360,000 of the estimated $560,000 annual cost savings. A whopping 64% of the cost saving is based on fuel reduction so actual cost savings will be closely correlated to changes in fuel costs over the next decade. NPV calculations are based on the assumption that gas prices remain stable over the next decade. Over the last 10 years, gas prices on average rose 6.5% but much of this increase is attributed to the drastic rise in price in 1980 and 1981, in the wake of the Iranian Revolution when global oil supply experienced disruption. Exclude these 2 years, and the average increase to gas prices falls to a modest 1.3, with the 3 most recent years in decline (See Figure 3). Given the conflicting indicators on the future

direction of gas price, this NPV model conservatively assumes stable gas prices over the next 10 years. If gas prices increases then the cost savings will be increasingly favorable. Since cost saving is correlated with increased fuel pricing, purchasing the new equipment provides a hedge; falling fuel prices diminish the cost savings but benefit Paperco overall profits. In contrast, rising fuel costs increase the NPV for the purchase but hurt Papercos overall profit. This hedging factor reduces risk and thus makes the purchase increasingly attractive. Inflation rates are also presented in Figure 3. Inflation averaged 7.4% in the past decade but has stabilized to a more suitable 3-4 percent range over the last few years. Annual inflation rates are not expected to materially impact the purchase decision, assuming it remains below 4%. Figure 3: Retail Gas Prices and Inflation (1975-1985)

Economic Growth and Paper Demand The economic outlook for the next decade is expected to remain favorable. GDP has rebounded nicely since its 1982 low as shown in Figure 4. Despite a significant drop in US paper consumption in 1982, due to the economic recession, the longer term trend clearly shows growing paper consumption on a per capita basis (See Figure 5). Factor in growing US and international population and demand should remain strong. Demand will further accelerate due to the adoption of personal computers in both the office and residential setting, as computer users print their output. Although additional investments would need to be made to overall manufacturing infrastructure in order to increase production levels, having the new drying equipment makes this component of our manufacturing capability more scalable.

Figure 4: Annual US GDP

Figure 5: Paper Consumption (US and China) - Kg per person per year

Adapted from http://chrislang.files.wordpress.com/2008/02/us_china_finland.png

Recommendation Summary
Proceeding with the Pressco purchase is supported by NPV analysis, economic conditions and anticipated demand growth. Even under the worse-case scenario where the investment tax credit is lost and 7-year depreciation is enacted, losses are relatively modest, when compared with the upside under the other two tax scenarios. Multiplying the probability of each scenario by its expected return results in an expected saving of $113,000. Growing demand and modest increases to fuel price over the next decade should further boost return on investment by eight percent annually.

References
http://inflationdata.com/Inflation/Inflation_Rate/HistoricalInflation.aspx http://www.multpl.com/us-gdp-inflation-adjusted/table http://www1.eere.energy.gov/vehiclesandfuels/facts/m/2012_fotw741.html http://chrislang.files.wordpress.com/2008/02/us_china_finland.png

Appendix 1: Financial Analysis of Pressco Purchase Agreement

Scenario1:NoChangeinTaxLegislation

Scenario2:NewTaxRate,GrandfatheredDepreciationandTaxCredit

Scenario3:NewTaxRate,NoInvestmentTaxCredit,7yearDepreciation