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%.

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.)

Answer 1

Old Equipment
Purchase Cost	120	$ mn
Life	5	Years
Age	2	Years
Salvage Value	13	$ mn
Depreciation/Yr	21.4	Straight line Method -> = (120-13)/5 in $ mn
Book Value Today	77.2	=120-2*21.4 in $mn
Re-sale value today	80	$ mn
Capital Gain	2.8	$ mn (80-77.2)
New Equipment
Installation Cost	150	$mn
Life	3	Years
Salvage Value	0	$mn
Depreciation/Yr	50	$mn (Straight Line Method)
Sales Increase	25	$mn
Cost Decrease	10	$mn
Tax Rate	35%
Discount Rate	10%

Cash Flows	0	1	2	3		Notes
Sale of Old Equipment	80.00
Capital Gain Tax on Sale of Equipment	(0.98)					=Capital Gain * Tax = 2.8*35%
Purchase of new equipment	(150.00)
Increase in Sales		25.00	25.00	25.00
Add: Cost Reduction		10.00	10.00	10.00
Less: Additional Depreciation		(28.60)	(28.60)	(28.60)		=Depreciation on Old Machine - New Machine
Additional Profit before tax		6.40	6.40	6.40
Tax on additional Profit		(2.24)	(2.24)	(2.24)
Additional Net Profit		4.16	4.16	4.16
Addback Depreciation as non-cash Exp		28.60	28.60	28.60
Cash Flow	(70.98)	32.76	32.76	32.76		Additional Net Profit + Depreciation
Discount Rate	1	0.909091	0.826446	0.751315
Discounted Cash Flow	(70.98)	29.78	27.07	24.61
Net Present Value of replacement project	10.49	Answer C				Sum of Discounted Cash Flows
IRR	18.22%					=IRR(Cash Flows)
Net Cash flow at time 0	(70.98)	Answer A
Intermidiate Cash Flows		Answer B
Year 1	32.76
Year 2	32.76
Year 3	32.76