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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.
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