New Economy Transport (A)
The New Economy Transport Company (NETCO) was formed in 1959 to carry cargo and passengersbetween ports in the Pacific Northwest and Alaska. By 2012 its fleet had grown to fourvessels, 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 financedirector, has just been presented with a proposal that would require the following expenditures:
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Overhaul engine and generators
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$340,000
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Replace radar and other electronic equipment
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75,000
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Repairs to hull and superstructure
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310,000
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Painting and other repairs
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95,000
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$820,000
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Mr. Handy believes that all these outlays could be depreciated for tax purposes in the seven-yearMACRS class.
NETCO's chief engineer, McPhail, estimates the postoverhaul operating costs as follows:
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Fuel
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450,000
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Labor and benefits
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480,000
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Maintenance
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141,000
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Other
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110,000
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$1,181,000
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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, butcould 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 animmediate 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, whichwould cost an extra $600,000. 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:
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Fuel
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$400,000
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Labor and benefits
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405,000
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Maintenance
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105,000
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Other
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110,000
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|
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$1,020,000
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Overhaul of the Vital Spark would take it out of service for several months. The overhauledvessel would resume commercial service next year. Based on past experience, Mr. Handybelieves that it would generate revenues of about $1.4 million next year, increasing with inflationthereafter.
But the Vital Spark cannot continue forever. Even if overhauled, its useful life is probably nomore than 10 years, 12 years at the most. Its salvage value when finally taken out of service willbe trivial.
NETCO is a conservatively financed firm in a mature business. It normally evaluates capitalinvestments using an 11% cost of capital. This is a nominal, not a real, rate. NETCO's tax rate is 35%.
QUESTION
Calculate the NPV of the proposed overhaul of the Vital Spark, with and without the newengine and control system. To do the calculation, you will have to prepare a spreadsheet tableshowing all costs after taxes over the vessel's remaining economic life. Take special care withyour assumptions about depreciation tax shields and inflation.