The following mini case is part of the textbook solutions portion of this site.
ID: 2710563 • Letter: T
Question
The following mini case is part of the textbook solutions portion of this site. As I'm working through the case, the textbook solution provides an inflation rate of 13.78% when solving the problem. I'm not sure where where they are getting 13.78%, as the case below clearly states that inflation is 2.5%. I really need to know why/how the textbook solution came up with the 13.78% before I can move forward. I know that you're not able to see the textbook solution, however I'm not able to post a copy of it here so you can see it......not really sure what to do....
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:
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 “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.
Page 158
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:
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
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.
Explanation / Answer
The 13.78 % is not inflation rate but it is real discount rate to account for inflation and can be arrived as follows :
Real rate = nominal rate + inflation + (nominal rate x inflation rate)
= 0.11 + .025 + (0.11 x 0.025)
= 0.135 + 0.00275
=.1378
= 13.78%
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