Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $155 million on equipment with an assumed life of 5 years and an assumed salvage value of $25 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $110 million. A new modem pool can be installed today for $180 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 $24 million per year and decrease operating costs by $12 million per year. At the end of 3 years, the new equipment will be worthless. Assume the firm’s tax rate is 30% and the discount rate for projects of this sort is 15%. Required:

What is the net cash flow at time 0 if the old equipment is replaced?

Answer 1

To calculate the net cash flow at time 0 for PC Shopping Network, we must consider the sale of old equipment, purchase of new equipment, associated tax effects, operational cash flow changes, and discounting future cash flows at the required discount rate of 15%.

Step-by-step explanation:

The calculation of the net cash flow at time 0 when the old equipment is replaced by PC Shopping Network requires consideration of various financial aspects, including the initial cost of the new equipment, the salvage value of the old equipment, the tax implications of selling the old equipment, and the associated increase in sales and decrease in costs from the new equipment.

Firstly, to calculate the depreciation of the old equipment, we would take the initial cost of $155 million, subtract the salvage value of $25 million, and divide by the asset's assumed lifespan of 5 years to find the annual depreciation. Over two years, the accumulated depreciation would be $52 million, leaving a book value of $103 million. Selling the old equipment at $110 million would result in a gain on sale, which is taxable.

Therefore, the tax due to the gain would be 30% of ($110 million - $103 million). Secondly, the cost of the new equipment would total $180 million, plus the tax paid on the gain of sale, but that cost could potentially be offset by the immediate cash inflow from selling the old equipment.

The new equipment enables an increase in sales by $24 million and a decrease in costs by $12 million annually, which are operational cash flows that will affect net income and taxes. As these benefits accrue over the life of the new equipment, we consider the present value of these cash flows discounted back to time 0. Lastly, the new equipment is being depreciated to zero over its 3-year life, which will have tax benefits as well.