Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $145 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 $100 million. A new modem pool can be installed today for $180 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 $27 million per year and decrease operating costs by $14 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 8%.

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

Answer to a

We need to compute first the book value of the Old Pool at the end of Year 2

Purchase Price - $145 Million

Salavge Value at the end of 5 years for Tax Purpose - $15 Million.

Depriciation on straight line Method Per year = (145-15)/5 = $ 26 Million

Now Calculating the Book Value of the old pool at the end of year 2 = $ 145 Million - ($ 26 Million*2 Years)

=$ 93 Million.

Now Calculating the gain on Sale of Old Pool = $ 100 Million - $ 93 Million. =$7 Million.

Therefore Tax on Sale of Old Pool = $7 Million*30%= $ 2.1 Million

Now Cash Outflow Flow at the time 0 = New Purchase Price of pool- Proceeds of Old Pool+ Tax on Gain on sale of old pool

=$180 Million-$100 Million+$2.1 Million

Cash flow At Year 0 = - $ 97.9 million.

Answer to b

Computation of Increamental Cash Flows at year 1,2 and 3, we need to compute the increamental Depriciation Tax Shield

Depriciation on New Pool = $ 180 Million /3 Years = $ 60 Million

Depriciation on OId Machinery = $ 26 Million

Increamental Depriciation = $34 Million

Tax Savings due to Increamental Depriciation = $ 34 Million * 30%

=$ 10.2 Million

Now, we need to compute Increamental Post tax Savings

=[Increase in Sales + Savings in Operating Cost]*(1-Tax%)

=[$ 27 Million +$ 14 Million]*(1-.030)

= $ 287 Million

Adding the Depriciation Tax Sheild to the above we will get the increamental Cash Flows

= $ 28.7 Million + $ 10.2 Million

=$ 38.9 Million

Therefore Increamental Cash flows at the end of Year 1,2 and 3 = $ 38.9 Million each.

Answer to c

NPV = Initial Outflow- Present Value of Cash Inflows

Initial Outflow as computed above in answer a = -97.9 Million

Increamental Cash Outflows in year 1,2 and 3 as computed in answer b = $ 38.9 Million

Therefore NPV = -97.9 + 38.9/1.08+38.9/(1.08)^2+38.9/(1.08)^3

NPV = $ 2.35 Million

Answer to d

IRR is the Internal rate of the Return of the project where NPV is 0

Computing the same on Excel

The working of the same is below

The same can also be computed by using the hit and trial method, whereby we compute the present values of the cash inflows at year 1,2,3 using a discount rate closer to 8% in order to make the NPV 0. Therefore IRR = 9.32 %