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

a) To find the net cash outlay at time 0 we need to first find the proceeds from the sale of the old equipment. For this we need to find its book value so as to calculate the tax applicable.

Depreciation per year of old equipment = (Purchase price - Salvage value)/Useful Life

= (105-11)/5 = $18.8 million

Therefore, the current book value = Purchase price - Accumulated Depreciation= 105 -(2*18.8)= 105 - 37.6 = $67.4 million

Current Selling Value = $80 million

Therefore, tax will be applicable on (Sale price - Book Value) = 80 - 67.4 = $12.6 million

Proceeds from sale after taking tax effect into consideration = 80 - (0.35*12.6) = $75.59 million

Net cash outflow at time 0 = New pool purchase cost - Proceeds from sale = 150 - 75.59 = $74.41 million

b) The new equipment results in increase in sales of $25 million per year and decrease in operating costs by $10 million per year.

Therefore, savings = 25 + 10 = $35 million per year

However, tax will be paid on this.

Savings after tax = 35 * (1 - 0.35) = $22.75 million

Depreciation on new equipment = (150 - 0)/3 = $50 million per year

There will be depreciation tax shield = 50 * 0.35 = $17.5 million per year

Incremental Cash flows = Savings after tax + Depreciation tax shield = 22.75 + 17.5 = $40.25 million per year for the three years

c)

Formulas Used:

Therefore, NPV = $25.69 million

IRR = 28.74%