PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, wh
ID: 2819043 • Letter: P
Question
PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $95 million on equipment with an assumed life of 5 years and an assumed salvage value of $18 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%.
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.)
Explanation / Answer
a. Cash flow at time 0 if the old equipment is replaced: - $ 81.83 million.
Workings :
Book value of old equipment = $ ( 95 - 18 ) / x 3 = $ 46.20 million.
Tax on gain on salvage = $ ( 80 - 46.20 ) x 0.35 = $ 11.83 million
Net salvage proceeds = $ 80 - $ 11.83 = $ 68.17 million.
Cash outflow at time 0 = Net salvage proceeds - Cost of new Equipment = $ 68.17 million - $ 150 million = - 81.83 million.
b. Incremental cash flows : $ 34.86 million.
Incremental cash flows = Incremental Savings x ( 1 - t ) + Incremental Depreciation x t
Incremental savings per year = $ 25 million + $ 10 million = $ 35 million.
Incremental depreciation per year = $ (150 / 3 ) million - $ ( 95 - 18) million / 5 = $ 34.6 million.
Cash flows in year 1, 2 and 3 = $ 35 million x 0.65 + $ 34.6 million x 0.35 = $ 22.75 million + $ 12.11 million = $ 34.86 million.
c. NPV of the replacement project = $ 34.86 x 2.4869 - $ 81.83 million = $ 4.86 million.
( 2.4869 = 1 / 1.10 + 1 / ( 1.10 )2 + 1 / ( 1.10) 3 )
IRR : 13 %
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