The New Economy Transport Company (NETCO) was formed in 1959 to carry cargo and passengers between ports in the Pacific Northwest and Alaska. By 2012 its fleet had grown to four vessels, 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 finance director, has just been presented with a proposal that would require the following expenditures:

Overhaul engine and generators $340,000

Replace radar and other electronic equipment 75,000

Repairs to hull and superstructure 310,000

Painting and other repairs 95,000 

Total $820,000

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 post-overhaul operating costs as follows:

Fuel 450,000 $

Labor and benefits 480,000

Maintenance 141,000

Other 110,000 

Total $1,181,000

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, 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 $600,000.¹⁶ 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:

Fuel 400,000 $

Labor and benefits 405,000

Maintenance 105,000

Other 110,000 

TOTAL $1,020,000

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 $1.4 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

Calculate the NPV And The IRR of the proposed overhaul of the Vital Spark, with and without the new engine and control system. .what do you think should be the decision of the management of New Economy Transport ?