Question

Your company, VZ, is evaluating the proposal of replacing one of its old cell phone towers with one with built-in new technology and GPS supporting system. The old tower has a book value of $600,000 and a remaining useful life of 5 years. The firm does not expect to realize any return from scrapping the old tower in 5 years, but it can be sold today to another wireless provider today for $265,000. The old system is being depreciated toward a zero salvage value by $120,000 using straight line method. The new system has a purchase price of $1,175,000, an estimated useful life and MACRS class life of five years, and an estimated market value of $145,000 at the end of five years. The new towers is expected to allow VZ obtain additional customers to increase its revenue by $230,000 per year and also reduce cost due to maintenance, compensating customers for dropped calls which save an additional $25,000 annually. Verizon’s marginal tax rate is 36%.

1. What is the investment outlay of the system for capital budgeting purposes?

2. Calculate the annual depreciation allowances for both machines, and compute the change in the annual depreciation expense if the replacement is made.

3. What are the incremental operating cash flows in Year 1 through 5?

4. What is the terminal cash flow in Year 5?

5. If the project’s required rate of return is 12%, should the project be pursued? What if the required rate of return is 18%? What if the required rate of return is 8%?

6. In general, how would each of the following factors affect the investment decision and how should each be treated?

   1. The expected life of the existing machine decreases?

   2. The required rate of return is not constant but is increasing as VZ adds more projects into its capital budget?

Answer 1

Answer:

Book value of old tower = $600000

Sale value = $265,000

Capital loss = 600000 - 265000 = $335,000

Tax benefit on loss = 36% *335000 = $120,600

Investment outlay of the system for capital budgeting purposes = cost of new system - Sale value of old tower + Tax benefit on loss

= $1,175,000 - $265,000 - $120,600

= $789,400

Investment outlay of the system for capital budgeting purposes = $789,400

Change in the annual depreciation expense if the replacement is made:

Incremental operating cash flows in Year 1 through 5 and terminal cash flow in Year 5 are calculated below:

If project’s required rate of return is 12%, NPV is = $9,526.45. Since NPV is positive, project should be accepted.

If project’s required rate of return is 18%, NPV is = - $98,152.40. Since NPV is negative, project should be rejected.

If project’s required rate of return is 8%, NPV is = $97,302.45. Since NPV is positive, project should be accepted.

Workings:

If the expected life of the existing machine decreases, NPV will decrease.

If the required rate of return is not constant but is increasing, then NPV will decrease as required return increases.