TransPacific Shipping is considering replacing an existing s hip with one of two newer, more efficient ones. The existing ship is three years old, cost $32 million, and is being depreciated under MACRS using a five-year recovery period.
Although the existing ship has only three years (years 4,5, and 6) of depreciation remaining under MACRS, it has a remaining usable life of five years. Ship A, one of the two possible replacement ships, costs $40,000 million to purchase and $8 million to outfit for service.
It has a five-year usable life and will be depreciated under MACRS using a five-year recovery period. Ship B costs $54 million to purchase and $6 million to outfit. It also has a five-year usable life and will be depreciated under MACRS using a five-year recovery period.
Increased investments in net working capital will accompany the decision to acquire ship A or ship B. Purchase of ship A would result in a $4 million increase in net working capital; ship B would result in a $6 million increase in net working capital. The projected profits before depreciation and taxes for each alternative shipo and the existing ship are given in the following table.
Profits Before Depreciation & Taxes
Year Ship A Ship B Existing Ship
1 $21,000,000 $22,000,000 $14,000,000
2 21,000,000 24,000,000 14,000,000
3 21,000,000 26,000,000 14,000,000
4 21,000,000 26,000,000 14,000,000
5 21,000,000 26,000,000 14,000,000
The existing ship can currently be sold for $18 millioon and will not incur any removal or cleanupcosts. At the end of five years, the existing ship can be sold to net $1 million before taxes.
Ships A and B can be sold to net $12 million and $20 million before taxes, respectively, at the end of the five-year period. The firm is subject to a 40% tax rate on both ordinary income and capital gains.
a. Calculate the initial outlay associated with each alternative.
b. Calculate the operating cash flows associated with each alternative. Be sure to consider the depreciation in year 6.
c. Calculate the terminal cash flow at the end of year 5, associated with each alternative.
d. Depict on a time line the incremental cash flows associated with each alternative.