Question
The Little Transport Company (LTC) was formed in 1970 to carry cargo and passengers between ports in the Baltic Sea. By 2017 its fleet had
The Little Transport Company (LTC) was formed in 1970 to carry cargo and passengers between ports in the Baltic Sea. By 2017 its fleet had grown to four vessels, including a small dry-cargo vessel, the Aurora.
The Aurora is 25 years old and badly in need of an overhaul. Andres, the finance director, has just been presented with a proposal that would require the following expenditures:
Overhaul engine and generators | $350,000 |
Replace radar and other electronic equipment | 80,000 |
Repairs to hull and superstructure | 310,000 |
Painting and other repairs | 100,000 |
| $840,000 |
Andres also believes that these outlays could be fully depreciated for tax purposes at straight-line depreciation rates for their useful life. LTC's chief engineer, Tnu, estimates the post-overhaul annual initial operating costs as follows:
Fuel | $450,000 |
Labour and benefits | 480,000 |
Maintenance | 140,000 |
Other | 110,000 |
| $1,180,000 |
These costs generally increase with inflation, which is forecasted at 3 per cent a year.
The Aurora is carried on LTCs books at a net depreciated value of $100,000 but could probably sold "as is", along with an extensive inventory of spare parts, for $220,000. The book value of spare parts inventory is $50,000. Sale of the Aurora 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 navigation system, which would cost an extra $600,000. This extra investment would also qualify for the same depreciation mentioned above. This additional equipment would not substantially improve the Auroras performance, but would result in the following reduced annual fuel, labour, and maintenance costs:
Fuel | $400,000 |
Labour and benefits | 405,000 |
Maintenance | 105,000 |
Other | 110,000 |
| $1,020,000 |
Overhaul of the Aurora would take it out of service for several months. The overhauled vessel would resume commercial service only after a year. Based on the past experience, it is believed that it would generate revenues of about 1.4 million dollars next year, increasing with inflation thereafter. But the Aurora cannot continue forever. Even if overhauled, its useful life is probably no more than 10 years. Its salvage value when finally taken out of service will be trivial.
LTC is conservatively financed firm in a mature business. It normally evaluates capital investments using a 12 per cent cost of capital. LTC is subject to a corporate tax rate (on profits and capital gains) at 35%.
Your task:
Calculate the NPV of the proposed overhaul of the Aurora with and without the new engine and navigation system? To do the calculation, you will have to prepare comprehensive table showing all cash flows after taxes over the vessel's remaining economic life.
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