MINI$$CASE

New Economy Transport $($A$)$

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

ports in the Pacific Northwest and Alaska. By $2015$ its fleet had grown to four vessels, including a small drycargo vessel, the Vital 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:

Mr$.$ Handy believes that all these outlays could be depreciated for tax purposes in the seven$$year MACRS class.

NETCO's chief engineer, McPhail, estimates the postoverhaul operating costs as follows:

These costs generally increase with inflation, which is forecasted at $2\mathrm{.}5\%$ a year.

The Vital Spark is carried on NETCO's books at a net depreciated value 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.$ This additional outlay would also qualify for tax depreciation in the seven$-$year MACRS class.

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:

Overhaul of the Vital Spark would take it out of service for several months. The overhauled vessel would resume

commercial service next year. Based on past experience, Mr$.$ Handy believes that it would generate revenues of

about $$1\mathrm{.}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 evaluates capital investments using

an $11\%$ cost of capital. This is a nominal, not a real, rate. NETCO's tax rate is $35\%.$

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.