Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $115 million on equipment with an assumed life of 5 years and an assumed salvage value of $15 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 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

Old equipment

Book value = (purchase price)*remaining life/total life
= (115)*3/5
= 69

Time line		0	1	2	3
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	56
Tax shield on existing asset book value	=Book value * tax rate	20.7
Cost of new machine		-150
=a. Initial Investment outlay		-73.3
						100.00%
Sales			25	25	25
Profits	Sales-variable cost	25	25	25
Operating cost			10	10	10
-Depreciation	Cost of equipment/no. of years	-50	-50	-50	0	=Salvage Value
=Pretax cash flows			-15	-15	-15
-taxes	=(Pretax cash flows)*(1-tax)	-10.5	-10.5	-10.5
+Depreciation			50	50	50
=b. after tax operating cash flow			39.5	39.5	39.5
+Tax shield on salvage book value	=Salvage value * tax rate			0
=Terminal year after tax cash flows					0
Total Cash flow for the period		-73.3	39.5	39.5	39.5
Discount factor=	(1+discount rate)^corresponding period	1	1.1	1.21	1.331
Discounted CF=	Cashflow/discount factor	-73.3	35.90909091	32.6446281	29.67693464
c. NPV=	Sum of discounted CF=	24.93

Time line		0	1	2	3
Proceeds from sale of existing asset	=selling price* ( 1 -tax rate)	56
Tax shield on existing asset book value	=Book value * tax rate	20.7
Cost of new machine		-150
=Initial Investment outlay		-73.3
Sales			25	25	25
Profits	Sales-variable cost	25	25	25
Operating cost			10	10	10
-Depreciation	Cost of equipment/no. of years	-50	-50	-50
=Pretax cash flows			-15	-15	-15
-taxes	=(Pretax cash flows)*(1-tax)	-10.5	-10.5	-10.5
+Depreciation			50	50	50
=after tax operating cash flow			39.5	39.5	39.5
+Tax shield on salvage book value	=Salvage value * tax rate			0
=Terminal year after tax cash flows					0
Total Cash flow for the period		-73.3	39.5	39.5	39.5
Discount factor=	(1+discount rate)^corresponding period	1	1.284827634	1.65078205	2.120970396
Discounted CF=	Cashflow/discount factor	-73.3	30.74342343	23.92805277	18.62355084
NPV=	Sum of discounted CF=	0.00
d. IRR is discount rate at which NPV = 0 =	28.48%