New Economy Transport - Principles of Corporate Finance
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Problem
New Economy Transport (A)
The New Economy Transport Company (NETCO) was formed in 1959 to carry cargo and passengers between ports in the Pacific Northwest and Alaska. By 2015 its fleet had grown to four vessels, including a small dry-cargo vessel, the Vital Spark.
The Vital Spark is 25 years old and badly in need of an overhaul. Peter Handy, the finance director, has just been presented with a proposal that would require the following expenditures:
Mr. Handy believes that all these outlays could be depreciated for tax purposes in the seven-year MACRS class.
NETCO’s chief engineer, McPhail, estimates the postoverhaul operating costs as follows:
These costs generally increase with inflation, which is forecasted at 2.5% a year.
The Vital Spark is carried on NETCO’s books at a net depreciated value of only $100,000, but could probably be sold “as is,” along with an extensive inventory of spare parts, for $200,000. The book value of the spare parts inventory is $40,000. Sale of the Vital Spark would generate an immediate tax liability on the difference between sale price and book value.
The chief engineer also suggests installation of a brand-new engine and control system, which would cost an extra $600,000.16 This additional equipment would not substantially improve the Vital Spark’s performance, but would result in the following reduced annual fuel, labor, and maintenance costs:
Overhaul of the Vital Spark would take it out of service for several months. The overhauled vessel would resume commercial service next year. Based on past experience, Mr. Handy believes that it would generate revenues of about $1.4 million next year, increasing with inflation thereafter. But the Vital Spark cannot continue forever. Even if overhauled, its useful life is probably no more than 10 years, 12 years at the most. Its salvage value when finally taken out of service will be trivial.
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NETCO is a conservatively financed firm in a mature business. It normally evaluates capital investments using an 11% cost of capital. This is a nominal, not a real, rate. NETCO’s tax rate is 35%.
Calculate the NPV of the proposed overhaul of the Vital Spark, with and without the new engine and control system. To do the calculation, you will have to prepare a spreadsheet table showing all costs after taxes over the vessel’s remaining economic life. Take special care with your assumptions about depreciation tax shields and inflation.
Step-by-step solution
Net Present Value (NPV) is the difference between the present values of the inflow and outflow. In other words, the difference between the present value of the inflows and required investment is known as NPV.
Present value is the current value of the future amount/amounts that can occur at a specific time in the future.
If the NPV is positive, the project/investment will be accepted. If the NPV is negative, the project/investment will be rejected.
Following is the equation of the NPV:
Here, PV stands for the present value and stands for cash flow in year 0.
Comment
Here, the requirement is to find the NPV of the overhauling.
Calculate NPV after overhaul without Brand-new engine and control system if life would be 10- years using spreadsheet.
Enter values and formulas in the spreadsheet as shown in the image below.
The obtained result is provided below.
Step 1 of 8
Step 2 of 8
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Therefore, the NPV is .
Comments (1)
Calculate NPV after overhaul without Brand-new engine and control system if life would be 12- years using spreadsheet.
Enter values and formulas in the spreadsheet as shown in the image below.
Comments (1)
The obtained result is provided below.
Step 3 of 8
Step 4 of 8
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Therefore, the NPV is .
Comment
Calculate NPV after overhaul with Brand-new engine and control system if life would be 10-years using spreadsheet.
Enter values and formulas in the spreadsheet as shown in the image below.
Comment
The obtained result is provided below.
Step 5 of 8
Step 6 of 8
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Therefore, the NPV is .
Comment
Calculate NPV after overhaul with Brand-new engine and control system if life would be 12-years using spreadsheet.
Enter values and formulas in the spreadsheet as shown in the image below.
Comment
The obtained result is provided below.
Step 7 of 8
Step 8 of 8
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Therefore, the NPV is .
Comment
2 0
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