Florida Power & Light (FP&L) is the primary subsidiary of Florida Power & Light Group, representing 84% of their earnings. FP&L is a utility company that supplies electric service throughout most of Florida's eastern seaboard. Their service area contains 27,605 square miles which translates into approximately 4 million customers. Of these 4 million customers, as a percentage of operating income, roughly 55% comes from residential customers, 35% from commercial, 4% from industrial, and the remaining 6% from other sources.
Paul Seiler, a senior contracts agent in the nuclear division at FP&L's Turkey Point Plant in Florida City, Florida, is debating on whether to renew or replace the commercial nuclear reactor's reactimeter. A reactimeter is a vital component of the nuclear power generating process.
The core of a nuclear reactor must be maintained at a certain temperature and must possess a particular chemical composition. Any deviation from this sensitive optimal mix will result in the sub-optimization of the plant and a corresponding waste of energy. The reactimeter is a computer with accompanying software that is used to monitor the requisite characteristics of the Reactor Coolant System (RCS) and make minor adjustments as needed.
Alternative 1:
In order to determine whether the reactimeter should be renewed or replaced, Paul had to gather some financial information. If the current computer system is upgraded and new software is purchased, the cost will be $80,000. An additional $5,000 will be required to have the system installed and calibrated for accuracy. The renewed computer system will have a useful life of just five years and will be depreciated in compliance with the MACRS five year recovery system. Depreciation rates for years one through five are .20, .32, .19, .12, and .12, respectively. Only the purchase cost of $80,000 will be depreciable, not the installation cost.
At the end of the five year period, the renewed machine can be sold for $5,000 before taxes. The renewed machine would also result in an increase in net working capital of $20,000. Net profits resulting from an increase in operational efficiency for each year will be as follows:
Table 1
Year Net increase in profits
1 $650,000
2 $425,000
3 $317,000
4 $220,000
5 $129,000
Alternative 2:
The new system will also have a five year life and will be depreciated in compliance with the MACRS five year recovery system. The fully depreciable cost of the new system will be $100,000. Installation costs will be an additional $5,000. At the end of the five year period, the renewed machine can be sold for $10,000 before taxes. Implementing the new machine would result in an increase in net working capital of $15,000. If FP&L decides to replace the old system with a new reactimeter, the resulting net profits will be:
Table 2
Year Net increase in profits
1 $350,000
2 $350,000
3 $350,000
4 $350,000
5 $350,000
If a new system is purchased, the old system can be salvaged for $10,000. Finally, FP&L has a 40% corporate tax rate.
Questions
1. What is the initial investment associated with both alternatives?
2. Calculate the net after-tax operating cash inflows associated with both alternatives.
3. Calculate the year 5 cash flow associated with the sale of the computer for both alternatives. That is, remember to consider that both computer systems can be sold at the end of the fifth year.
4. Using a discount rate of 10%, calculate the present value of both alternatives. Which alternative should Paul choose?
5. What are some of the qualitative factors to consider when making a decision between the two alternatives?
6. Based on your answers from questions 4 and 5, has your decision changed concerning which alternative is preferred?