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 :$380,000

Labor and benefits :330,000

Maintenance :70,000

Other : 105,000

$885,000

The crew would require additional training to handle the new vessel?s more complex and sophisticated

equipment. Training would probably cost $50,000 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 out-of-pocket costs, of as

much as $100,000 per year. Moreover, a new vessel would have a useful service life of 20 years

or more.

16This additional outlay would also qualify for tax depreciation in the seven-year MACRS class.

Making Investment Decisions with the Net Present Value Rule 159

Cohn and Doyle offered the new vessel for a fixed price of $3,000,000, 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 she?s never let us down.? I?ll 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

20-year NPV spreadsheet, but I don?t have a clue how the replacement will be used in 2027 or

2032. 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

1. Calculate and compare the equivalent annual costs of (a) overhauling and operating the

Vital Spark for 12 more years, and (b) buying and operating the proposed replacement vessel

for 20 years. What should Mr. Handy do if the replacement?s annual costs are the same or

lower?

2. Suppose the replacement?s equivalent annual costs are higher than the Vital Spark ?s. What

additional information should Mr. Handy seek in this case?

Rev.confirming pages Chapter 6 Making Investment Decisions with the Net Present Value Rule 157 b. Suppose the inflation rate increases to 25%. The real interest rate stays at 6%. Recalculate the level nominal annuities. Note that the ranking of machines A and B appears to change. Why? 34. Project NPV In December 2005 Mid-American Energy brought online one of the largest wind farms in the world. It cost an estimated $386 million and the 257 turbines have a total capacity of 360.5 megawatts (mW). Wind speeds fluctuate and most wind farms are expected to operate at an average of only 35% of their rated capacity. In this case, at an electricity price of $55 per megawatt-hour (mWh), the project will produce revenues in the first year of $60.8 million (i.e., .35 3 8,760 hours 3 360.5 mW 3 $55 per mWh). A reasonable estimate of maintenance and other costs is about $18.9 million in the first year of operation. Thereafter, revenues and costs should increase with inflation by around 3% a year. Conventional power stations can be depreciated using 20-year MACRS, and their profits are taxed at 35%. Suppose that the project will last 20 years and the cost of capital is 12%. To encourage renewable energy sources, the government offers several tax breaks for wind farms. a. How large a tax break (if any) was needed to make Mid-American's investment a positiveNPV venture? b. Some wind farm operators assume a capacity factor of 30% rather than 35%. How would this lower capacity factor alter project NPV? 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 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 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: Fuel Labor and benefits $ 450,000 480,000 Maintenance 141,000 Other 110,000 $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. bre34760_ch06_130-159.indd 157 Visit us at www.mhhe.com/bma $820,000 10/27/12 10:50 AM Rev.confirming pages 158 Part One Value 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 $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 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. Take special care with your assumptions about depreciation tax shields and inflation. 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 Visit us at www.mhhe.com/bma Maintenance bre34760_ch06_130-159.indd 158 Other $380,000 330,000 70,000 105,000 $885,000 The crew would require additional training to handle the new vessel's more complex and sophisticated equipment. Training would probably cost $50,000 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 out-of-pocket costs, of as much as $100,000 per year. Moreover, a new vessel would have a useful service life of 20 years or more. 16 This additional outlay would also qualify for tax depreciation in the seven-year MACRS class. 10/27/12 10:50 AM Rev.confirming pages Chapter 6 Making Investment Decisions with the Net Present Value Rule 159 Cohn and Doyle offered the new vessel for a fixed price of $3,000,000, 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 she's never let us down.\" I'll 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 20-year NPV spreadsheet, but I don't have a clue how the replacement will be used in 2027 or 2032. 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 1. Calculate and compare the equivalent annual costs of (a) overhauling and operating the Vital Spark for 12 more years, and (b) buying and operating the proposed replacement vessel for 20 years. What should Mr. Handy do if the replacement's annual costs are the same or lower? Visit us at www.mhhe.com/bma 2. Suppose the replacement's equivalent annual costs are higher than the Vital Spark 's. What additional information should Mr. Handy seek in this case? bre34760_ch06_130-159.indd 159 10/27/12 10:50 AM