Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $85 million on equipment with an assumed life of 5 years and an assumed salvage value of $25 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $70 million. A new modem pool can be installed today for $150 million. This will have a 3-year life and will be depreciated to zero using straight-line depreciation. The new equipment will enable the firm to increase sales by $23 million per year and decrease operating costs by $11 million per year. At the end of 3 years, the new equipment will be worthless. Assume the firm’s tax rate is 30% and the discount rate for projects of this sort is 10%.

Required:

a. What is the net cash flow at time 0 if the old equipment is replaced? (Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.)

b. What are the incremental cash flows in years (i) 1; (ii) 2; (iii) 3? (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.)

c. What is the NPV of the replacement project? (Do not round intermediate calculations. Enter the NPV in millions rounded to 2 decimal places.)

d. What is the IRR of the replacement project? (Do not round intermediate calculations. Enter the IRR as a percent rounded to 2 decimal places.)

Answer 1

a)

Depreciation on old machine

= (purchase price - salvage ) / useful life

= (85 - 25) / 5

= 12 million

Depreciation for 2 years = 2 * 12 = 24

Book value after 2 years = 85 - 24 = 61

Sale value of old machine = 70

Gain on sale = sale value - book value

= 70 - 61= 9

Tax on gain = 9 * 30% = 2.7

After tax salvage value = 70 - 2.7 = 67.3

Net cash flow = price of new machine - after tax sale value of old machine

= 150 - 67.3

= $82.70

b)

Depreciation on new machine = 150 / 3 = 50

Depreciation on old machine = 12

Net depreciation = 50 - 12 = 38

Incremental cash flows :

=( Increase in sales+decrease in cost)*(1-tax) + net depreciation*(tax)

= (23 + 11)*(1-30%) + 38*30%

= 23.80 + 11.40

= $35.20

c)

NPV :

So NPV = $4.84

(formula for npv can be seen in formula bar)

d)

IRR:

IRR = 13.29%