Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $105 million on equipment with an assumed life of 5 years and an assumed salvage value of $11 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $80 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 $25 million per year and decrease operating costs by $10 million per year. At the end of 0 years, the new equipment will be worthless. Assume the firm’s tax rate is 35% and the discount rate for projects of this sort is 10%. 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 1, 2, and 3? (Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.) c. What are the NPV and IRR of the replacement project? (Do not round intermediate calculations. Enter the NPV in millions rounded to 2 decimal places. Enter the IRR as a percent rounded to 2 decimal places.)

Answer 1

Book value of old machine

		Book value = (purchase price-Final book value)*remaining life/total life+final book value
		= (105-11)*3/5+11
	= 67.4

Time line		0	1	2	3
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	52
Tax shield on existing asset book value	=Book value * tax rate	23.59
Cost of new machine		-150
=a. Initial Investment outlay		-74.41
Profits			35	35	35
-Depreciation	Cost of equipment/no. of years		-50	-50	-50
=Pretax cash flows			-15	-15	-15
-taxes	=(Pretax cash flows)*(1-tax)		-9.75	-9.75	-9.75
+Depreciation			50	50	50
=b. after tax operating cash flow			40.25	40.25	40.25
+Tax shield on salvage book value	=Salvage value * tax rate				0
=Terminal year after tax cash flows					0
Total Cash flow for the period		-74.41	40.25	40.25	40.25
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331
Discounted CF=	Cashflow/discount factor	-74.41	36.59090909	33.264463	30.240421
c. NPV=	Sum of discounted CF=	25.69

Total Cash flow for the period		-74.41	40.25	40.25	40.25
Discount factor=	(1+discount rate)^corresponding period	1	1.287429113	1.6574737	2.1338799
Discounted CF=	Cashflow/discount factor	-74.41	31.26385725	24.283945	18.862355
NPV=	Sum of discounted CF=	0.000156582
IRR is discount rate at which NPV = 0 =	28.74%