PC Shopping Network may upgrade its modem pool. It last upgraded 2 years ago, when it spent $115 million on equipment with a life of 5 years and a salvage value of $15 million. The old equipment can be sold today for $80 million. A technology consultant hired by PC Shopping Network has suggested that a new modem pool can be installed today for $150 million. This will have a 3-year life with a salvage value of $30 million. Both the 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. The consultant's fee, payable this month, is $10,000.
The new equipment will enable the firm to increase sales by $25 million per year and decrease operating costs by $10 million per year. It will also require the firm to keep $5 million of extra inventory on hand. The additional inventory will not be needed after the useful life of the equipment. Assume the firm's tax rate is 35% and the discount rate for projects of this sort is 12%.
a. If the company decides to replace their existing modem pool with the new equipment, sales will increase and costs will decline. What is the impact of these changes for the firm's cash flow? In other words, find the present value of the incremental cash flows over the life of the project that result from the changes in sales and costs.
b. Replacing the old equipment with new equipment results in changes to the company's asset class and therefore changes to its depreciation tax shield. Find the PV of the depreciation tax shield associated with replacing the equipment.
c. Should the company replace the modem pool? Support your decision by finding the NPV of replacing the equipment.
You have been asked to choose between two pollution devices. The "Wet Scrub" costs $1,000 to set up and $500 per year to operate. It must be completely replaced every 3 years and it will have a salvage value of $100 when replaced. The "Dry Scrub" device costs $2,000 to set up but only $300 a year to operate. It lasts for 5 years and has no salvage value. In order to arrive at these estimates for the operating costs, you hired a consultant who has invoiced the company for $350. Both devices can be depreciated using straight line depreciation and the tax rate for the firm is 30%. Assuming that pollution control equipment is replaced as it wears out, and that the cost of capital is 10%, which device do you recommend?