PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $115 million on equipment with an assumed life of 5 years and an assumed salvage value of $15 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 3 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 12%.
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?
d. Now ignore straight-line depreciation and assume that both new and old equipment are in an asset class with a CCA rate of 30%. PC Shopping Network has other assets in this asset class. What is the NPV of the replacement project? For this part, assume that the new equipment will have a salvage value of $30 million at the end of 3 years.