PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, wh
ID: 2740669 • Letter: P
Question
PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $90 million on equipment with an assumed life of 5 years and an assumed salvage value of $30 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $90 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 $24 million per year and decrease operating costs by $12 million per year. At the end of 3 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 14%.
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.)
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.)
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.)
PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $90 million on equipment with an assumed life of 5 years and an assumed salvage value of $30 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $90 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 $24 million per year and decrease operating costs by $12 million per year. At the end of 3 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 14%.
Explanation / Answer
a. The net cash flow at time 0 if the old equipment is replaced = - $ 102.60 million
Initial investment = Sale proceeds of old equipment - Initial investment on new equipment = $ ( 180 - 77.40 ) = - $ 102.60 million.
After tax salvage value of the old equipment:
Accumulated depreciation on old equipment = $ 90 million / 5 x 2 = 36 million
Book value = 90 million - 36 million = 54 million.
Gain on salvage = $ 90 million - $ 54 million = $ 36 million.
Tax liability on gain = $ 36 million x 35 % = $ 12.60 million
After tax salvage value = $ 90 million - $ 12.60 million = $ 77.40 million.
b. Incremental cash flows per year : $ 38.10 million
Incremental revenues = $ ( 24 + 12) = 36 million
Incremental depreciation = 180 million / 3 - 18 million = 42 million.
Annual incremental cash flows = 36 million x ( 1 - 0.35) + 42 million x 0.35 = $ 38.10 million
c. NPV of the replacement project = - $ 14.15 million
NPV = Net cash flows in period 0 + (Incremental annual net cash flows x PVIFA 14%, 3 years) = 38.10 x 2.3216 - 102.60 = - $ 14.15 million
PV factor = Initial investment / Net annual cash flows = 102.60 / 38.10 = 2.6929
This PV factor corresponds to IRR of 5.60 %
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