TransPacific Shipping is considering replacing an existing ship with one of two
ID: 2613555 • Letter: T
Question
TransPacific Shipping is considering replacing an existing ship with one of two newer, more efficient ones. The existing ship is three years old, cost $32 million, and is being depreciated under MACRS using a 5-year recovery period. Although the existing ship has only three years (years 4, 5, and 6) of depreciation remaining under MACRS, it has a remaining usable life of five years. Ship A, one of the two possible replacement ships, costs $40 million to purchase and $8 million to outfit for service. It has a 5-year usable life and will be depreciated under MACRS using a 5-year recovery period. Ship B costs $54 million to purchase and $6 million to outfit. It also has a 5-year usable life and will be depreciated under MACRS using a 5-year recovery period. Increased investments in net working capital will accompany the decision to acquire ship A or ship B. Purchase of ship A would result in a $4 million increase in net working capital; ship B would result in a $6 million increase in net working capital. The projected profits before depreciation and taxes with each alternative ship and the existing ship are given in the following table.
The existing ship can currently be sold for $18 million and will not incur any removal or cleanup costs. At the end of five years, the existing ship can be sold to net $1 million before taxes. Ships A and B can be sold to net $12 million and $20 million before taxes, respectively, at the end of the 5-year period. The firm is subject to a 40 % tax rate on both ordinary income and capital gains.
a. Calculate the initial outlay associated with each alternative.
b. Calculate the operating cash flows associated with each alternative. Be sure to consider the depreciation in year 6.
c. Calculate the terminal cash flow at the end of year 5 associated with each alternative.
d. Depict on a time line the incremental cash flows associated with each alternative.
Explanation / Answer
Initial Outlay:
Description
Ship A
Ship B
Existing
Cost
40.00
54.00
NA
Outfit cost
8.00
6.00
NA
Initial Outlay
$ 48.00
$ 60.00
$32.00
Depreciation rate chart for 5 yrs:
Depreciation rate
5-year
1
20.00%
2
32.00%
3
19.20%
4
11.52%
5
11.52%
6
5.76%
Year
Ship A
Ship B
Existing
1
$ 9,600,000.00
$ 12,000,000.00
$ 3,686,400.00
2
$ 15,360,000.00
$ 19,200,000.00
$ 3,686,400.00
3
$ 9,216,000.00
$ 11,520,000.00
$ 1,843,200.00
4
$ 5,529,600.00
$ 6,912,000.00
$ -
5
$ 5,529,600.00
$ 6,912,000.00
$ -
6
$ 2,764,800.00
$ 3,456,000.00
$ -
Net cash inflow
Year
Ship A
Ship B
Existing
1
$ 11,400,000.00
$ 10,000,000.00
$ 10,313,600.00
2
$ 5,640,000.00
$ 4,800,000.00
$ 10,313,600.00
3
$ 11,784,000.00
$ 14,480,000.00
$ 12,156,800.00
4
$ 15,470,400.00
$ 19,088,000.00
$ 14,000,000.00
5
$ 15,470,400.00
$ 19,088,000.00
$ 14,000,000.00
6
$ (2,764,800.00)
$ (3,456,000.00)
$ -
57,000,000.00
64,000,000.00
60,784,000.00
Incremental cashflow compareing with Existing
Year
Ship A
Ship B
1
$ 5,913,600.00
$ 8,313,600.00
2
$ 11,673,600.00
$ 15,513,600.00
3
$ 7,372,800.00
$ 9,676,800.00
4
$ 5,529,600.00
$ 6,912,000.00
5
$ 5,529,600.00
$ 6,912,000.00
6
$ 2,764,800.00
$ 3,456,000.00
Terminal Cashflow
Year
Ship A
Ship B
Existing
yr 5
$ 12.00
$ 20.00
Description
Ship A
Ship B
Existing
Cost
40.00
54.00
NA
Outfit cost
8.00
6.00
NA
Initial Outlay
$ 48.00
$ 60.00
$32.00
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