Question

New Economy Transport (A)

The New Economy Transport Company (NETCO) was formed in 1959 to carry cargo and passengers

between ports in the Pacific Northwest and Alaska. By 2012 its fleet had grown to four

vessels, including a small dry-cargo vessel, the Vital Spark.

The Vital Spark is 25 years old and badly in need of an overhaul. Peter Handy, the finance

director, has just been presented with a proposal that would require the following expenditures:

Overhaul engine and generators	$340,000
Replace radar and other electronic equipment	75,000
Repairs to hull and superstructure	310,000
Painting and other repairs	95,000
	$820,000

Mr. Handy believes that all these outlays could be depreciated for tax purposes in the seven-year

MACRS class.

NETCO’s chief engineer, McPhail, estimates the postoverhaul operating costs as follows:

Fuel	450,000
Labor and benefits	480,000
Maintenance	141,000
Other	110,000
	$1,181,000

These costs generally increase with inflation, which is forecasted at 2.5% a year.

The Vital Spark is carried on NETCO’s books at a net depreciated value of only $100,000, but

could probably be sold “as is,” along with an extensive inventory of spare parts, for $200,000.

The book value of the spare parts inventory is $40,000. Sale of the Vital Spark would generate an

immediate tax liability on the difference between sale price and book value.

The chief engineer also suggests installation of a brand-new engine and control system, which

would cost an extra $600,000. (This additional outlay would also qualify for tax depreciation in the 7 year MACRS class). This additional equipment would not substantially improve the

Vital Spark ’s performance, but would result in the following reduced annual fuel, labor, and

maintenance costs:

Fuel	$400,000
Labor and benefits	405,000
Maintenance	105,000
Other	?110,000
	$1,020,000

Overhaul of the Vital Spark would take it out of service for several months. The overhauled

vessel would resume commercial service next year. Based on past experience, Mr. Handy

believes that it would generate revenues of about $1.4 million next year, increasing with inflation

thereafter.

But the Vital Spark cannot continue forever. Even if overhauled, its useful life is probably no

more than 10 years, 12 years at the most. Its salvage value when finally taken out of service will

be trivial.

NETCO is a conservatively financed firm in a mature business. It normally evaluates capital

investments using an 11% cost of capital. This is a nominal, not a real, rate. NETCO’s tax rate is 35%.

QUESTION

1. Calculate the NPV of the proposed overhaul of the Vital Spark, with and without the new

engine and control system. To do the calculation, you will have to prepare a spreadsheet table

showing all costs after taxes over the vessel’s remaining economic life. Take special care with

your assumptions about depreciation tax shields and inflation.

Answer 1

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