Question
PC Shopping Network may upgrade its modem pool. It had previously upgraded 2 year ago, when it spent $115 million on equipment with an assumed
PC Shopping Network may upgrade its modem pool.
It had previously upgraded 2 year ago, when it spent $115 million on equipment with an assumed life of 5 years.
The firm uses straight-line depreciation, so old equipment is going to be fully depreciated 3 years from now (at the end of the 5-year life).
It is estimated that the old equipment can still be sold for $15 million at that time (3 years from now).
The current market price for the old equipment is $80 million.
A new modem pool can be installed today for $150 million.
This will have a 3-year life and will be depreciated to zero using straight-line depreciation.
The new equipment will enable the firm to increase sales by $25 million per year and decrease operating costs by $10 million per year.
At the end of 3 years, the new equipment will be worthless.
Assume the firms tax rate is 35%. The company is 100% equity financed and has an equity beta of 1.4. Risk free rate is 3% and the expected return on market portfolio is 8%.
a. (2 points) What is the required return on equity?
b. (2 points) What is the annual depreciation of the old equipment? What is the annual depreciation of the new model pool?
c. (5 points) What are the incremental earnings in year 0, 1, 2 and 3 from now on, if the old equipment is replaced by the new one?
d. (3 points) If PC Shopping decide not to have the old equipment replaced, but keep it till the end of its life. What is the cash inflow PC Shopping can get by reselling it then (three years from now)?
e. (3 points) If the old equipment gets replaced, what is the cash inflow PC shopping can get by selling the old equipment now on the market?
f. (5 points) Based on the results you found on part b - e, what are the incremental free cash flows of in year 0, 1, 2 and 3, if the old equipment is replaced? What is the NPV of this upgrade? According to NPV rule, should PC Shopping Network make this upgrade or not?
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