Question

In: Finance

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

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $140 million on equipment with an assumed life of 5 years and an assumed salvage value of $16 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.)

Solutions

Expert Solution

Part (a)

All financials below are in $ mn.

The net cash flow at time 0 if the old equipment is replaced = Sale value of old equipment - taxes on sale value - Purchase cost of new equipment

Annual depreciation on old equipment = (140 - 16) / 5 = 24.8

Book value of old equipment today = 140 - 24.8 x 2 = 90.4

Sale value = 80

Gain on sale = 80 - 90.4 = - 10.4

Tax rate, T = 35%

Hence, tax on gain on sale = Gain x T = - 10.4 x 35% = - 3.64

The net cash flow at time 0 if the old equipment is replaced = Sale value of old equipment - taxes on sale value - Purchase cost of new equipment = 80 - (- 3.64) - 150 = - 66.26 = - $ 66.26 mn

Part (b)

Annual depreciation on new machine = 150 / 3 = 50

Incremental depreciation on account of new machine = Annual depreciation of new machine - Annual depreciation of the old machine = 50 - 24.8 = 25.2

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. The last row highlighted in yellow is your answer. Figures in parenthesis mean negative values. All financials are in $ mn.

Year, n Linkage 1 2 3
Incremental sale A 25 25 25
Reduction in cost B 10 10 10
Incremental depreciation on account of new machine C -25.2 -25.2 -25.2
Incremental operating income D = A + B + C 9.8 9.8 9.8
Taxes E = - 35% x D -3.43 -3.43 -3.43
NOPAT F = D + E 6.37 6.37 6.37
Add back incremental depreciation -C 25.2 25.2 25.2
Salvage value lost on old machine S -16
Incremental cash flows F - C + S 31.57 31.57 15.57

Part (c)

Please see the table below. The last two rows highlighted in yellow contain your answers. Adjacent cells in blue contain the formula in excel I have used to get the final output in the yellow colored cell. All financials are in $ mn.


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