PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, wh
ID: 2789575 • Letter: P
Question
PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $110 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 $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 $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 8%.
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.)
Explanation / Answer
a)Depreciation on old equipment : [cost-salvage]/useful life
= [110-20]/5
= 18
Total depreciation for 2 years : 18*2=36
Book value Today : 110-36= 74
Gain on sale of old equipment = sale value -book value
= 80-74 = 6
Tax on gain :6 *.35 = 2.1
After tax sale value of equipment = 80-2.1 = 77.90
Initial cash flow : Purchase cost of new equipment- sale proceeds of old
= 150 -77.90
= - 72.1 [since cash outflow use - sign]
b)
1 2 3 Increase in revenue 24 24 24 Saving in operating cost 12 12 12 Depreciation [150/3] -50 -50 -50 Income before tax -14 --14 -14 Less:tax -4.9 [-14*.35] -4.9 -4.9 Income after tax -9.1 [-14-(-4.9)] -9.1 -9.1 Add:Depreciation 50 50 50 cash flow 40.9 40.9 40.9Related Questions
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