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 $17 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.)

Net cash flow _________ million

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.)

Incremental cash flow____________million per year

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.)

NPV________million

IRR________%

Answer 1

a]

book value of old equipment now = purchase price - accumulated depreciation

Depreciation per year on old equipment = (purchase price - salvage value) / useful life = ($90 million - $17 million) / 5 = $14,600,000

Accumulated depreciation for 2 years = $14,600,000 * 2 = 29,200,000

book value of old equipment now = $90,000,000 - $29,200,000 = 60,800,000

Profit on sale of old equipment = sale price - book value = $80,000,000 - $60,800,000 = 19,200,000

Cash flow from sale of old equipment = sale price - (profit * (1 - tax rate)) = $80,000,000 - ($19,200,000 * (1 - 35%)) = $73,280,000

Net cash outflow at time 0 = cost of new equipment - cash flow from sale of old equipment = $150,000,000 - $73,280,000 = $76,720,000

b]

incremental profit = (increase in sales + decrease in operating costs - incremental depreciation) * (1 - tax rate)

annual depreciation on new equipment = cost / useful life = $150 million / 3 = $50 million

incremental depreciation = depreciation on new equipment - depreciation on old equipment = $50 million - $14,600,000 = $35,400,000

incremental profit = ($25,000,000 + $10,000,000 - $35,400,000) * (1 - 35%) = -$260,000

Incremental cash flow = incremental profit + incremental depreciation = -$260,000 + $35,400,000 = $35,140,000

c]

NPV and IRR are calculated using NPV function in Excel