Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $130 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 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

1-	cost of old equipment	-130
	accumulated depreciation till today =(130-15)/5 = 23*2 = 46	-46
	book value today =130-46	-84
	less selling price	80
	loss on sale of equipment	-4
	tax benefit on loss on sale of equipment	1.4
	sale proceeds with tax benefits = 80+1.4	81.4
	cost of new equipment	-150
	less sale value of old equipment with tax benefit	81.4
	net cash outflow	-68.6
2-	Year	incremental annual savings =(25+10)	less incremental depreciation (50-23) =150/3 = 50	operating annual saving	after tax annual saving = 35% of operatin annual saving	net operating cash flow = after tax saving+ incremental depreciation	present value of annual operating cash flow = cash flow/(1+r)^n r= 10%
	1	35	27	8	5.2	32.2	29.27273
	2	35	27	8	5.2	32.2	26.61157
	3	35	27	8	5.2	32.2	29.27273
				sum of present value of cash flow			85.15702
				cash outflow			-68.6
				NPV			16.55702
3-	Year	annual operating cash flow
	0	-68.6
	1	32.2
	2	32.2
	3	32.2
	IRR = IRR function in MS excel =irr(-68.6,32.2,32.2,32.2)	19.28%