Question

Show all calculation please.

4) Crackle and Pop Telephone Company is considering an upgrade to their current call-waiting equipment. Their existing hardware was purchased 3 years ago for $150,000, has been depreciated straight line over a 5-year useful life (so, two years of depreciable life are remaining), and has an estimated current market value of $70,000. Bob Crackle (owner of the firm) estimates that the current equipment could probably last 5 more years (from today) at which time its market value will equal $0. A replacement piece of equipment costs $300,000, and can be depreciated straight line over 3 years. This new equipment will last 5 years, at which time its market (scrap) value will equal $10,000. Due to enhanced features, acquiring this new equipment would lead to a $10,000 revenue increase in the first year (t=1). These revenues would grow by $4,000 per year for the subsequent four years (t = 2, 3, 4, 5). (So, revenues will be $10,000, $14,000, 18,000….. higher.) In addition, due to its higher quality construction, it would lead to a decrease in operating expenses of $7,000 per year at times t =1,2,3,4, and 5. (So, expenses are lower by $7,000, $7,000, $7,000….) Due to the increase in revenues, accounts receivable will likely rise. Mr. Crackle estimate that AR will go from the exiting level of $12,000 to $18,000 at time 1, $20,000 at times 2, 3, and 4, and back to $12,000 at time 5. If the required return for this type of project is 12% and the tax rate is 40%, should the replacement piece of equipment be acquired? Be sure to provide quantitative justification for your answe

Answer 1

Year	0	1	2	3	4	5
Existing system
Depreciation		30,000	30,000
Salvage						0
Additional expense/ earning	0	0	0	0	0	0
Tax benefit of depreciation		3,600	3,600	-	-	-
FCFF	-	3,600	3,600	-	-	-
PV	-	3,214	2,870	-	-	-
NPV of existing system	6,084
New system
Purchase price	300,000
Salvage (new+ current)	70,000					10,000
Revenue increase		10,000	14,000	18,000	22,000	26,000
Expense decrease		7,000	7,000	7,000	7,000	7,000
Additional EBIDTA	(230,000)	17,000	21,000	25,000	29,000	43,000
Depreciation		100,000	100,000	100,000
EBIT	(230,000)	(83,000)	(79,000)	(75,000)	29,000	43,000
Tax	(92,000)	(33,200)	(31,600)	(30,000)	11,600	17,200
PAT	(138,000)	(49,800)	(47,400)	(45,000)	17,400	25,800
WC increase		6,000	2,000	-	-	(8,000)
FCFF	(138,000)	44,200	50,600	55,000	17,400	33,800
PV of FCFF	(138,000)	39,464	40,338	39,148	11,058	19,179
NPV of new system	11,187

Tax in case of loss is added back to EBIT to arrive at PAT since this loss can be harvested and the tax break can be used to lower the tax liability at any other unit in the firm. FCFF= EBIT *(1-Tax)+Depreciation- Change in WC- investment in fixed asset. FCFF of existing system will comprise only of tax benefit of depreciation since there are no additional benefits from continuing with the existing system. We can captured all the additional benefits (lower expense and higher revenue) in the FCFF calculations of the new system

We can see that the NPV of implementing new system is higher than the NPV of continuation of the existing system. Hence, we can go for implementing new system