Question

PC Shopping Network may upgrade its modern pool it lar t upgraded 2 years ago, when it spent $110 million on equipment with an assumed Me of 5 years and an assumed salvage value of $10 million for tax purposes. The firm uses straight-ine 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 rero 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 O 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 O if the old equipment is replaced? (Negetive amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places) Not cash fow b. What are the incremental cash flows in years 1,2, and 3? (Do not round intermediate calculotions. Enter your answer in millions rounded to 2 decimal places-) 1, 2. and 32 (Do not round intermediate calculotions. Enter your answer in cremental cash fow milian par 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 piaces. Enter the IRR as a percent rounded to 2 decimal places.) milion

Answer 1

Answer a:

Net Cash Flow $73.50 million

Workings;

(in $ million)

Depreciation schedule of Old equipment: Year Cost Depreciation Book Value 0 2 4 $110 20 20 20 20 20 $90 $70 $50 $30 $10

Book value of old equipment = $70 million

Sale value of old equipment now = $80 million

Tax on gain = 35% * (80 - 70) = $3.5 million

Sales value net of gain = 80 - 3.5 = $76.5 million

Net cash flow at time 0 = Sale proceeds of old equipment net of tax - cost of new modern pool = 76.50 - 150.00

= - $73.50 million

Answer b:

Incremental cash flow | $33.25 Imillion per year

Workings:

In $million 2 Year Cost of new modern pool Sale proceeds of old equipment net of tax Incremental sale $25.00 $10.00 $25.00$25.00 $10.00 $10.00 Saving in operating cost $50.00) Depreciation of old equipment(S20.00) ($30.00) Net Incremental savings before t $5.00 S1.75) Net Incremental savings after tax$3.25 $30.00 Depreciation of new machine ($50.00) ($50.00) $20.00) ($20.00 ($30.00)($30.00 Incremental depreciation $5.00 $5.00 $1.75) ($1.75 $3.25 $3.25 $30.00$30.00 $33.25$33.25 Tax on incremental savings Add back depreciation Incremental cash flow per year $33.25

Answer c:

$1.67 million 11.37 % IRR

Workings:

Salvage value of old equipment is assumed (as given) = $10 million

In $million 2 Year Cost of new modern pool Sale proceeds of old equipment 0 $150.00 $76.50 25.00 $25.00 10.00 $10.00 Incremental sale $25.00 $10.00 Saving in operating cost Depreciation of new machine Depreciation of old equipment Incremental depreciation Net Incremental savings before tax Tax on incremental savings Net Incremental savings after tax Add back depreciation Incremental cash flow Terminal cash flow Salvage value of new machine Salvage value of old machine Incremental salvage value $50.00 $20.00 $30.00 $5.00 $1.75 $3.25 $30.00 $33.25 $50.00-$50.00 20.00-$20.00 30.00-$30.00 $5.00 $5.00 $1.75-$1.75 $3.25$3.25 $30.00$30.00 $33.25$33.25 ear $0.00 $10.00 $10.00 Cash flow PV factor ( 1/(1+10%)^Year) Discounted cash flow NPV IRR 73.50$33.25 1 0.909091 3.50 $30.23 $33.25 $23.25 0.826446 0.751315 $27.48$17.47 $1.67 million 11.37%