Depreciation and Vital Spark Essay

p. 182The New Economy Transport Company (NETCO) was formed in 1955 to carry cargo and passengers between ports in the Pacific Northwest and Alaska. By 2008 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: 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: 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 â€Å"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 $600,000.15 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: 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. p. 183 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: 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. 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. â€Å"A rusty old tub,† he muttered, â€Å"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. â€Å"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 2023 or 2028. 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?