# Calculate the NPV of the proposed overhaul of the Vital Spark, with and without the new engine and control system.

## Question:

Calculate the NPV of the proposed overhaul of the Vital Spark, with and without the new engine and control system. To do the calculation, you will have to prepare a spreadsheet table showing all costs after taxes over the vessel’s remaining economic life. Take special care with your assumptions about depreciation tax shields and inflation.

The New Economy Transport Company (NETCO) was formed in 1959 to carry cargo and passengers between ports in the Pacific Northwest and Alaska. By 2018, its fleet had grown to four vessels, including a small dry-cargo vessel, the Vital Spark. The Vital Spark is 25 years old and badly in need of an overhaul. Peter Handy, the finance director, has just been presented with a proposal that would require the following expenditures:

Overhaul engine and generators ................................ \$340,000
Replace radar and other electronic equipment ............ 75,000
Repairs to hull and superstructure ............................... 310,000
Painting and other repairs ...........................................      95,000
\$820,000

Mr. Handy believes that all these outlays could be written off immediately for tax purposes. NETCO’s chief engineer, McPhail, estimates the postoverhaul operating costs as follows:

Fuel .......................................................... \$ 450,000
Labor and benefits ................................... 480,000
Maintenance ............................................. 141,000
Other .....................................................      110,000
\$1,181,000

These costs generally increase with inflation, which is forecasted at 2.5% a year.

The Vital Spark is carried on NETCO’s books at a net depreciated value of only \$100,000, but could probably be sold “as is,” along with an extensive inventory of spare parts, for \$200,000. The book value of the spare parts inventory is \$40,000. Sale of the Vital Spark would generate an immediate tax liability on the difference between sale price and book value.

The chief engineer also suggests installation of a brand-new engine and control system, which would cost an extra \$600,000.16 This additional equipment would not substantially improve the Vital Spark’s performance, but would result in the following reduced annual fuel, labor, and maintenance costs:

Fuel ......................................................... \$ 400,000
Labor and benefits .................................. 405,000
Maintenance ............................................ 105,000
Other ...................................................       110,000
\$1,020,000

Overhaul of the Vital Spark would take it out of service for several months. The overhauled vessel would resume commercial service next year. Based on past experience, Mr. Handy believes that it would generate revenues of about \$1.4 million next year, increasing with inflation thereafter.

But the Vital Spark cannot continue forever. Even if overhauled, its useful life is probably no more than 10 years, 12 years at the most. Its salvage value when finally taken out of service will be trivial.

NETCO is a conservatively financed firm in a mature business. It normally evaluates capital investments using an 11% cost of capital. This is a nominal, not a real, rate. NETCO’s tax rate is 21%.

Salvage Value
Salvage value is the estimated book value of an asset after depreciation is complete, based on what a company expects to receive in exchange for the asset at the end of its useful life. As such, an asset’s estimated salvage value is an important...

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Related Book For

## Principles of Corporate Finance

ISBN: 978-1260013900

13th edition

Authors: Richard Brealey, Stewart Myers, Franklin Allen

Question Details
Chapter # 6
Section: Mini case
Problem: 1
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