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The New Economy Transport Company ( NETCO ) was formed in 1 9 5 9 to carry cargo and passengers between ports in the Pacific
The New Economy Transport Company NETCO was formed in to carry cargo and passengers between ports in the Pacific Northwest and Alaska. By its fleet had grown to four vessels, including a small drycargo vessel, the Vital Spark.
The Vital Spark is 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 $
Replace radar and other electronic equipment $
Repairs to hull and superstructure $
Painting and other repairs $
Total $
Mr Handy believes that all these outlays could be written off immediately for tax purposes.
NETCO's chief engineer, McPhail, estimates the post overhaul operating costs as follows:
Fuel $
Labor and benefits $
Maintenance $
Other $
Total $
These costs generally increase with inflation, which is forecasted at a year.
The Vital Spark is carried on NETCO's books at a net depreciated value of only $ but could probably be sold as is along with an extensive inventory of spare parts, for $ The book value of the spare parts inventory is $ 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 brandnew engine and control system, which would cost an extra $ 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 $
Labor and benefits $
Maintenance $
Other $
TOTAL $
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 $ 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 years, 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 cost of capital. This is a nominal, not a real, rate. NETCO's tax rate is
QUESTION
Calculate the NPV of the proposed overhaul of the Vital Spark, with ad 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 vessels remaining economic life. Take special care with your assumptions about depreciation tax shields and inflations.
New Economy Transport B
There is no question that the Vital Spark needs an overhaul soon. However, Mr Handy feels it
unwise to proceed without also considering the purchase of a new vessel. Cohn and Doyle, Inc., a Wisconsin shipyard, has approached NETCO with a design incorporating a Kort nozzle, extensively automated navigation and power control systems, and much more comfortable accommodations for the crew. Estimated annual operating costs of the new vessel are:
Fuel $
Labor and benefits $
Maintenance $
Other $
Total $
The crew would require additional training to handle the new vessels more complex and sophisticated equipment. Training would probably cost $ next year.
The estimated operating costs for the new vessel assume that it would be operated in the same way as the Vital Spark. However, the new vessel should be able to handle a larger load on some routes, which could generate additional revenues, net of additional outofpocket costs, of as
much as $ per year. Moreover, a new vessel would have a useful service life of years or more.
Cohn and Doyle offered the new vessel for a fixed price of $ payable half immediately and half on delivery next year.
Mr Handy stepped out on the foredeck of the Vital Spark as she chugged down the Cook Inlet.
A rusty old tub, he muttered, but shes never let us down. Ill bet we could keep her going until next year while Cohn and Doyle are building her replacement. We could use up the spare parts to keep her going. We might even be able to sell or scrap her for book value when her replacement arrives.
But how do I compare the NPV of a new ship with the old Vital Spark? Sure, I could run a
year NPV spreadsheet, but I dont have a clue how the replacement will be used by the end of that time. Maybe I could compare the overall cost of overhauling and operating the Vital Spark to the cost of buying and operating the proposed replacement.
QUESTIONS
Calculate and compare the equivalent annual costs of a overhauling and operating the Vital Spark for more years, and b buying and operating the proposed replacement vessel for years. What should Mr Handy do if the replacement's annual costs are same or lower?
Suppose the replacement's equivalent annual costs are higher than the Vital Spark's. What additional information should Mr Handy seek in this case?
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