The New Economy Transport Company (NETCO) was formed in 1959 to carry cargo and passengers between...

 

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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 Vita! 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: $ 450,000 Fuel 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 vatue 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: $ 400,000 Fuel 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 wouid 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 evatuates capital investments using an 11% cost of capital. This is a nominal, not a real, rate. NETCO's tax rate is 21%. QUESTION 1. 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 Vita! 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: $ 450,000 Fuel 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 vatue 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: $ 400,000 Fuel 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 wouid 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 evatuates capital investments using an 11% cost of capital. This is a nominal, not a real, rate. NETCO's tax rate is 21%. QUESTION 1. 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.

Answer rating: 100% (QA)

Nominal Cost of Capital 11 Real Cost of Capital 1Nominal Rate1Inflation Rate 1 1111025 1 829 Tax bur... View the full answer