PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, wh
ID: 2764363 • Letter: P
Question
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 $20 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 $210 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 $28 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 35% and the discount rate for projects of this sort is 9%.
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.)
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.)
Explanation / Answer
a) The Net Cash flow at the time 0 if old equipment is replaced is determined as below
The Annual Depreciation of PC shopping network is determined by using following equation
Depreciation = ( Cost- Salvage Value)/Number of Years
Depreciation = ($140Million- $20Million)/5
Depreciation= $ 24 Million
Thus Annual Depreciation = $ 24 Million
The Book Value at the time of sale of PC Shopping network is determined by using following equation
Book Value= Cost- (Upgraded Years x Depreciation)
Book Value= $140Million-( 2x $ 24 Million)
Book Value = $ 92 Million
Now, the sale price is $100 Million so the net of tax proceed from sale is determined by using following equation
Net tax Proceed = sale price - ( tax rate x Profit)
Net tax Proceed = $100 Million - ( 0.35x 4.6 Million)
Net Tax Proceed = $ 98.39
The net cash outlay at time 0 is $ 210 - $ 98.39 = $ 111.61 Million
Increase in cash flow = ($ 28 + $ 14)x(1-0.35) + ($ 56 x 0.35)
Increase in cash flow = $ 46.9 Million
The NPV = - $111.61 Million + [ $ 46.9 Million xannuity factor (9%, 3 years)]
The NPV = - $111.61 Million + [$ 46.9 Million x 2.53129]
The NPV = $7.10772 Million
$111.61 = $ 46.9 Million{ 1/r-1/r*(1+r)3}
IRR = 12.539 %
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