NEW ECONOMY TRANSPORT (B)

Minicase solution, Chapter 6

Principles of Corporate Finance, 12th Edition

R. A. Brealey, S. C. Myers and F. Allen

We start with the assumptions and PV calculations in New Economy Transport

(A). We could calculate the NPV of the new vessel in the same format. But the new
vessel lasts for 20 years, 8 years longer than the rehabilitated Vital Spark. Thus we
calculate equivalent annual cash flows. That is, we calculate the equivalent annual costs
of the net investments required for the Vital Spark (with and without the new engine and
control system) and for the new vessel. The equivalent annual costs are subtracted from
net operating revenue.

The spreadsheet for New Economy Transport (B) summarizes the calculations.
The net investments are:

1. Overhaul of the Vital Spark (REHAB): The investment of $820,000 is offset by

the proceeds from sale as is (an opportunity cost of $179,000) and the present
value of depreciation tax shields ($201,108). The PV of net investment is
$439,892.

2. Overhaul with new engine (REHAB PLUS): Investment increases to $1,420,000,

but the PV of depreciation tax shields also increases. The PV of net investment is
$892,739.

3. New vessel: The PV of the $3,000,000 investment is only $2,851,351, because

half of the payment is deferred to t = 1. The PV of training costs is also treated as
an investment. In addition, NETCO can run the Vital Spark for one more year,
generating after-tax revenues of $910,000 and a salvage value of $140,000 at t =
1. Thus the net investment in the new vessel (PV) is $1,158,017.

The net investments are converted into equivalent annual costs, that is, real
annuities starting at t = 1.5 and continuing to t = 12.5 for the Vital Spark and to t = 20.5
for the new vessel. The equivalent annual costs per dollar of net investment are shown at
the bottom of the spreadsheet.

The total equivalent annual cash flow for each option equals revenues – operating
costs – equivalent annual cost of net investment. Overhaul of the Vital Spark generates a
positive annual flow, as expected, since overhaul is positive-NPV. But the new vessel
generates a larger equivalent annual cash flow of about +$274,000. Thus the Vital Spark
is headed for retirement at t = 1.

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