TelCo must decide whether to replace a computer system with a new model. TelCo forecasts net befoer-tax cost savings from the net computer over five years as given below (in $000). It has a 12% cost of capital, a 35% tax rate, and uses straight-line depreciation.
Year 1 2 3 4 5
($) 350 350 300 300 300
a. The new computer costs $1 million but TelCo is eligible for a 15% ITC in the first year. The ITC reduces TelCo's taxes by an amount equal to 15% of the equipment's purchase price. In addition, the old computer can be sold for $450,000. If the old computer originally cost $1.25 million and is three years old (depreciable, not economic, life is five years), what is the net investment required in the new system? Assume that there was no ITC on the old computer and that both computers are being depreciated to a zero salvage value.
b. Estimate the incremental operating cash flows associated with the new system.
c. If the new computer's salvage value at the end of five years is projected to be $100,000, should TelCo purchase it?