Question

PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $140 million on equipment with an assumed life of 5 years and an assumed salvage value of $20 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $100 million. A new modem pool can be installed today for $210 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 $28 million per year and decrease operating costs by $14 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 9%.

Required: What is the net cash flow at time 0 if the old equipment is replaced? Note: Negative amounts should be indicated by a minus sign. Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.
What are the incremental cash flows in years: (i) 1; (ii) 2; (iii) 3? Note: Do not round intermediate calculations. Enter your answer in millions rounded to 2 decimal places.
What is the NPV of the replacement project? Note: Do not round intermediate calculations.
Enter the NPV in millions rounded to 2 decimal places. What is the IRR of the replacement project? Note: Do not round intermediate calculations.
Enter the IRR as a percent rounded to 2 decimal places.

Answer 1

The net cash flow at time 0 if the old equipment is replaced is $110 million. The incremental cash flows in years 1, 2, and 3 are $14 million each. The NPV of the replacement project is calculated as the present value of the incremental cash flows minus the initial investment, with an IRR of 9%.

Step-by-step explanation:

To calculate the net cash flow at time 0 when replacing the old equipment, we need to consider the initial investment and the salvage value of the old equipment:

Net Cash Flow at Time 0 = Initial Investment - Salvage Value of Old Equipment

Given that the initial investment for the new modem pool is $210 million and the salvage value of the old equipment is $100 million, the net cash flow at time 0 is:

Net Cash Flow at Time 0 = $210 million - $100 million = $110 million (rounded to 2 decimal places)

The incremental cash flows in years 1, 2, and 3 can be calculated by considering the increase in sales and decrease in operating costs:

(i) Incremental Cash Flow in Year 1 = Increase in Sales - Decrease in Operating Costs = $28 million - $14 million = $14 million (rounded to 2 decimal places)

(ii) Incremental Cash Flow in Year 2 = Increase in Sales - Decrease in Operating Costs = $28 million - $14 million = $14 million (rounded to 2 decimal places)

(iii) Incremental Cash Flow in Year 3 = Increase in Sales - Decrease in Operating Costs = $28 million - $14 million = $14 million (rounded to 2 decimal places)

The NPV of the replacement project can be calculated by discounting the incremental cash flows with the discount rate and subtracting the initial investment:

NPV = (Incremental Cash Flow in Year 1 / (1 + Discount Rate)1) + (Incremental Cash Flow in Year 2 / (1 + Discount Rate)2) + (Incremental Cash Flow in Year 3 / (1 + Discount Rate)3) - Initial Investment

Using the given discount rate of 9%, the NPV of the replacement project is:

NPV = ($14 million / (1 + 0.09)1) + ($14 million / (1 + 0.09)2) + ($14 million / (1 + 0.09)3) - $210 million

IRR can be found by solving for the discount rate that makes the NPV equal to zero. In this case, the IRR is the discount rate that satisfies the equation:

0 = ($14 million / (1 + IRR)1) + ($14 million / (1 + IRR)2) + ($14 million / (1 + IRR)3) - $210 million

Answer 2

Internal Rate of Return (IRR):

IRR = 10.91% (approximately)

PC Shopping Network Modem Upgrade Analysis:

Net Cash Flow at Time 0:

Sale of old equipment: $100 million

Cost of new equipment: -$210 million

Book value of old equipment: $112 million (140 - 28)

Tax impact on disposal: ($112 - 100) x 30% = $3.6 million

Net cash flow: 100 - 210 + 112 + 3.6 = -$94.40 million

Incremental Cash Flows:

Year 1: 28 (sales) + 14 (cost savings) - 70 (depreciation) - 5.04 (tax on income) = $38.96 million

Year 2: 28 (sales) + 14 (cost savings) - 70 (depreciation) - 5.04 (tax on income) = $38.96 million

Year 3: 28 (sales) + 14 (cost savings) - 70 (depreciation) - 5.04 (tax on income) - 0 (equipment disposal) = $37.92 million

Net Present Value (NPV):

NPV =
`-$94.40 + 38.96 / (1 + 0.09)^1 + 38.96 / (1 + 0.09)^2 + 37.92 / (1 + 0.09)^3`

NPV = $19.43 million

Internal Rate of Return (IRR):

IRR = 10.91% (approximately)