Question

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 $10 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $100 million. A new modem pool can be installed today for $210 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 $40 million per year and decrease operating costs by $20 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 9%.

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

First we need to calculate the Net proceeds after tax from sale of old machine:-

Old machine purchase 2 yeas ago

Depreciation on old machine = (85 million - 10 million ) / 5 = $ 15 million per year.

Book value at the time of sale = $ 85 million - 2 years depreciation = $ 85 million - 15 million * 2 = $ 55 million

Sale proceeds from old machine	$ 100 million
Less- Book value of old machine at time of sale	$ 55 million
Gain on sale of old machine	$ 45 million
Less- Tax on gain @30%	$ 13.5 million
Net proceeds from sale of old machine after tax	$ 86.5 million

a) Calculation of the net cash flows at the time year 0 :-

Purchase of new modem pool	- $ 210 million
ADD- Net proceeds from sale of old machine	$ 86.5 million
Net Cash flow at year 0	- $ 123.5 million

b) Calculation of the  Incremental cash inflows for years 1,2,3 :-

Depreciation on new machine = $ 210 million / 3 = $ 70 million

Particulars	year 1,2,3
Increase in sales	$ 40 million
Add- decrease in operating cost	$ 20 million
Net increase in profit before depreciation	$ 60 million
Less- Increase in depreciation (70 million - 15 million)	$ 55 million
Incremental profit before tax	$ 5 million
Less- Tax@30%	$ 1.5 million
Incremental profit after tax	$ 3.5 million
Add- Increase in depreciation	$ 55 million
Net cash inflows per year	$ 58.5 million

c) NPV :-

NPV = present value cash inflows - initial investment

NPV = $ 58.5 million * PVAF (9%,3years) -  $ 123.5 million

NPV = $ 148.08074 million - 123.5 million

NPV = $ 24.58074 million

d) IRR :-

By using IRR function in ms Excel,

IRR = 19.86%