Reference no: EM133075632

Suppose that it is January 1990, and the New Economy Transport Company (NETCO) is evaluating a proposed expenditure of $400,000 for a new engine and general overhaul of one of its boats used to push barges up and down the Ohio River. The estimated annual operating costs after the overhaul are $1,234,000. The boat is fully depreciated, so that the depreciation tax shield from the decision to overhaul would be based on the incremental investment of $400,000.

The controller feels that it is unwise to proceed with the overhaul before considering the purchase of a new boat. A new boat would cost $2,000,000 payable now and with delivery in one year. The new boat would have annual operating costs of $800,000, and would require $50,000 in expenditures now to train a new crew to handle the more sophisticated equipment on board. The old boat could be sold today (as is) for $150,000. (These revenues can be treated as an offset to costs.)

The new boat would last 8 years whereas the old one would last another 4 years. (Assume the salvage values are zero.) The corporate tax rate is 34 percent; depreciation is on a straight-line basis of 25 percent per year (that is, $100,000 per year for 4 years on the overhaul option and $500,000 a year for 4 years on the new boat). The firm's opportunity cost of capital (discount rate) is 20 percent.

A. What is the value of the depreciation tax shield per year for the overhaul option?

B. What is the present value of the total costs of the overhaul option, taking into account the depreciation tax shield, operating costs, and the initial cost of the overhaul?

C. Derive the present value of the total costs associated with the purchase of the new boat at time 0, including all costs, the depreciation tax shield, and revenues from the sale of the old boat.

D. Which option, overhaul the old boat or purchase the new one, do you recommend on the basis of the information provided? Explain your reasoning.