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

Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $120 million on equipment with an assumed life of 5 years and an assumed salvage value of $13 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%.

Explanation / Answer

Equipment purchased two years back $120.00 Depreciation till date = ($120M - $13M)/5 x 2years $42.80 Book value of equipment $77.20 Less: Selling Price $80.00 Gain on Sale $2.80 Tax on Gain $0.98 a) Net cash flow at time 0 = $150 - (80 -.98) -$70.98 Million b) After Tax Cash Flows = Increase in revenue + decrease in operating costs x (1-Tax) After Tax Cash Flows = ($25 + $10) x (1-35%) $22.75 Depreciation Tax Shield = (Dep. New machine - Dep. old Machine= $150/3 - (($120-$13)/5 )x 35% $10.01 Annual Cash Flow = After tax Cash Flow + Depreciation Tax sield $32.76 Million Year Cash Flow PV @ 10% Present Value 0 -$70.98 1.0000 -$70.98 1 $32.76 0.9091 $29.78 2 $32.76 0.8264 $27.07 3 $32.76 0.7513 $24.61 NPV $10.49 Million IRR 18.22% a. What is the net cash flow at time 0 if the old equipment is replaced? -$70.98 b. What is the incremental cash flow in years 1-3? $32.76 c. What is the NPV and IRR of the replacement project? $10.49 NPV 18.22% IRR

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