Reference no: EM133055903
Question - The controller of the Economy Shipping Company, located near Pittsburgh, was preparing a report for the executive committee regarding the feasibility of repairing one of the company's steam riverboats or of replacing the steamboat with a new diesel-powered boat. The Economy Shipping Company was engaged mainly in the transportation of coal from the nearby mines to the steel mills, public utilities, and other industries within the Pittsburgh region. The boats owned by Economy Shipping were all steam powered and mostly between 15 and 25 years old.
The steamboat in question was the Conway, which was 23 years old and required either immediate rehabilitation or replacement. It was estimated that the Conway had a useful life of another 20 years provided that adequate repairs were made. The current book value of the Conway was $39,500, although the controller believed that the company could sell the boat right now for only around $25,000.
If they decided to rehabilitate the Conway, it would cost the company $115,000, although spare parts from another retired boat were available and would reduce the immediate rehabilitation costs from $115,000 to $71,500. The spare parts had a book value of $43,500, although the controller believed that if they were sold on the market, they would bring only around $30,000.
Currently, annual operating costs for the Conway were $200,000. The book cost of the Conway, including rehabilitation costs, would be depreciated over a 20-year period using the straight-line method. The controller estimated that the cost of dismantling and scrapping the Conway at the end of its useful life after the overhaul would be offset by the value of the scrap.
An alternative to rehabilitating the steamboat was the purchase of a diesel-powered boat for $325,000. An additional $75,000 for basic parts inventory would be necessary to service the diesel boat. The useful life of a diesel boat was estimated to be 25 years, at the end of which the boat would be scrapped or completely rehabilitated at a cost approximately equal to that of a new boat. However, if acquired, it was expected that the diesel boat would be sold at the end of the 20th year, at which time the hull of the boat would have a realizable value of $32,500 and the inventory of parts, $37,500. (The engines would be worthless after the 20th year.) The hull of the diesel boat ($265,000), the engines ($60,000), and the inventory of parts would be depreciated separately over a 20-year life using the straight-line method.
After consulting with other companies about the operations of a diesel boat, the controller estimated that the annual operating costs of such a boat would total $160,000.
At the time, other projects that management was considering had an estimated return of at least 10%. The income tax rate for the company was 42%.
Required -
1. Calculate the additional initial outlay associated with purchasing the new diesel boat. (In other words, calculate the incremental difference in the cash flows between the initial outlay associated with purchasing the diesel boat and the initial outlay associated with renovating the Conway.)
2. Calculate the additional depreciation associated with purchasing the new diesel boat. (In other words, calculate the incremental difference in the depreciation associated with purchasing the diesel boat and the depreciation associated with renovating the Conway.)
3. Calculate the additional annual operating cash flows (i.e., cost savings) associated with purchasing the new diesel boat. In other words, calculate the incremental difference between the annual operating cash flows associated with purchasing the diesel boat and the annual operating cash flows associated with renovating the Conway.
4. Calculate the additional terminal cash flows associated with purchasing the new diesel boat. (In other words, calculate the incremental difference in the cash flows between the terminal cash flows associated with purchasing the diesel boat and the terminal cash flows associated with renovating the Conway.)
5. Calculate the NPV for the project of purchasing the new diesel boat.
6. Based on your NPV calculation, what should be the conclusion about purchasing the new diesel boat?