Question

I'm really stuck on this one!

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 $19 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?

B.  What are the incremental cash flows in years 1, 2, and 3?

C. What are the NPV and IRR of the replacement project?

Answer 1

1-	cost of new pool		-150		cost of old pool		85
	less sale proceeds from old pool		72.51		accumulated depreciation for 2 years (85-19)/5))*2		26.4
	net cash outflow		-77.49		Book value at the end of year 2		58.6
					sale value		80
	net savings from new pool = increased sale+saving n cost	25+10	35		gain on sale of old pool	80-58.6	21.4
	less incremental depreciation		36.8		tax on gain on sale of old pool	21.4*35%	7.49
	net saving before tax		-1.8		net after tax sale proceeds	80-7.49	72.51
	less tax-35%		-0.63
	after tax savings		-1.17		Year	Depreciation on new pool = 150/3	depreciation on old pool	incremental depreciation
	add incremental depreciation		36.8		1	50	13.2	36.8
	net incremental cash flow		35.63		2	50	13.2	36.8
					3	50	13.2	36.8
2-	Year	Incremental cash flow	present value of incremental cash flowc = incremental cash flow/(1+r)6n r= 10%
	0	-77.49	-77.49
	1	35.63	32.39090909
	2	35.63	29.44628099
	3	35.63	26.76934636
3-	NPV = sum of present value of cash flow		11.11653644
	IRR using irr function in MS excel	irr(-77.49,35.63,35.63,35.63)	17.98%
	Depreciation on old pool	(85-19)/5	13.2