Principles of Corporate Finance_ 12th Edition

bre44380_ch06_132-161.indd 160 09/30/15 12:46 PM

160 Part One Value

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, exten-

sively automated navigation and power control systems, and much more comfortable accommoda-

tions for the crew. Estimated annual operating costs of the new vessel are:

Fuel $ 400,000

Labor and benefits 405,000

Maintenance 105,000

Other 110,000

$1,020,000

Fuel $380,000

Labor and benefits 330,000

Maintenance 70,000

Other 105,000

$885,000

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 main-

tenance costs:

(^16) This additional outlay would also qualify for tax depreciation in the seven-year MACRS class.
The crew would require additional training to handle the new vessel’s more complex and sophisti-
cated 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 immedi-
ately and half on delivery next year.