I\'m really stuck on this one! PC Shopping Network may upgrade its modem pool. I
ID: 2614970 • Letter: I
Question
I'm really stuck on this one!
PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $85 million on equipment with an assumed life of 5 years and an assumed salvage value of $19 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?
B. What are the incremental cash flows in years 1, 2, and 3?
C. What are the NPV and IRR of the replacement project?
Explanation / Answer
1-
cost of new pool
-150
cost of old pool
85
less sale proceeds from old pool
72.51
accumulated depreciation for 2 years (85-19)/5))*2
26.4
net cash outflow
-77.49
Book value at the end of year 2
58.6
sale value
80
net savings from new pool = increased sale+saving n cost
25+10
35
gain on sale of old pool
80-58.6
21.4
less incremental depreciation
36.8
tax on gain on sale of old pool
21.4*35%
7.49
net saving before tax
-1.8
net after tax sale proceeds
80-7.49
72.51
less tax-35%
-0.63
after tax savings
-1.17
Year
Depreciation on new pool = 150/3
depreciation on old pool
incremental depreciation
add incremental depreciation
36.8
1
50
13.2
36.8
net incremental cash flow
35.63
2
50
13.2
36.8
3
50
13.2
36.8
2-
Year
Incremental cash flow
present value of incremental cash flowc = incremental cash flow/(1+r)6n r= 10%
0
-77.49
-77.49
1
35.63
32.39090909
2
35.63
29.44628099
3
35.63
26.76934636
3-
NPV = sum of present value of cash flow
11.11653644
IRR using irr function in MS excel
irr(-77.49,35.63,35.63,35.63)
17.98%
Depreciation on old pool
(85-19)/5
13.2
1-
cost of new pool
-150
cost of old pool
85
less sale proceeds from old pool
72.51
accumulated depreciation for 2 years (85-19)/5))*2
26.4
net cash outflow
-77.49
Book value at the end of year 2
58.6
sale value
80
net savings from new pool = increased sale+saving n cost
25+10
35
gain on sale of old pool
80-58.6
21.4
less incremental depreciation
36.8
tax on gain on sale of old pool
21.4*35%
7.49
net saving before tax
-1.8
net after tax sale proceeds
80-7.49
72.51
less tax-35%
-0.63
after tax savings
-1.17
Year
Depreciation on new pool = 150/3
depreciation on old pool
incremental depreciation
add incremental depreciation
36.8
1
50
13.2
36.8
net incremental cash flow
35.63
2
50
13.2
36.8
3
50
13.2
36.8
2-
Year
Incremental cash flow
present value of incremental cash flowc = incremental cash flow/(1+r)6n r= 10%
0
-77.49
-77.49
1
35.63
32.39090909
2
35.63
29.44628099
3
35.63
26.76934636
3-
NPV = sum of present value of cash flow
11.11653644
IRR using irr function in MS excel
irr(-77.49,35.63,35.63,35.63)
17.98%
Depreciation on old pool
(85-19)/5
13.2