Incorporating a Brand-New Control System - Essay Example

Corporate Finance In the first scenario, Mark needs to be overhauled without incorporating a brand new control system. The revenue generated is $1.4 million after the plane is operational and this is after one year. Therefore, no revenue will be earned for the first year. Thereafter the revenue earned will be increased with inflation of 2.5%. Revenue for 2nd year = Revenue for 3rd year= Consecutively, the revenue for the other years is calculated similarly for 12 years as shown in Table 2. The total operating cost is $1,181,000. Similarly, the operating cost for the first year is 0 since the plane is not operational. These costs also increase with inflation. Operational cost for the 2nd year = Operational cost for 3rd year= The operational costs for the consecutive years are calculated in the same way. The initial cost for overhauling Mark 1 is $820,000. Tax depreciation is calculated using 7-year MACRS class. This is given in Table 1 below. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 14.29% 24.49% 17.49% 12.49% 8.93% 8.92% 8.93% 4.46% Table 1: MACRS method for 7-year schedule (IRS Publication 946) The 7 year MACRS goes for the first 8 years as shown in Table 1 above. Thereafter, it assumes a straight line depreciation method as indicated in IRS Publication 946. The tax depreciation for the first year is calculated as; The depreciation for the following years is calculated in the same way until year 8 when depreciation assumes straight linear method. In this case, the final salvage after 12 years is insignificant and in this calculation it is taken to be zero. Therefore, the depreciation for the last is uniform and equal to $ 9,143. The company’s tax rate is 35% hence the amount of company tax in each year is given by; The calculation of the Present Value (PV) is as follows; Where r is the evaluation of the capital investment in this case it is given as 11% cost of capital and t is the year in future. For the first year the present value on the cash flow= For the 2nd year the PV on the Cash Flow = The Net Present Value is the sum of the present values of all the years. In the second scenario, a brand new control system at a cost of $600,000 is installed. The revenue remains the same, but the operational costs are reduced to $1,020,000. The calculation of revenue, operational costs, tax depreciation, and pre-tax profit, company’s tax, after tax income, cash flow, present value and net present value are calculated as in the first scenario. However, in this second scenario the depreciation is calculated on an initial investment of $820,000+$600,000 = $1,420,000. Table 3 shows the results of calculations. The NPV in this case is $ 365,942.10. The third scenario is selling Mark 1 at the current market value of $ 200,000 including the spare parts. The book value of the plane is $100,000 and the book value of the spare parts is $40,000. The cost of overhauling Mark1 and operating it for 12 years is given by; Without installation of new control system With the installation of new control system In the two scenarios, overhauling mark 1 would take it out of service for 6 months and it would resume commercial operation after an year. In the calculation done, the revenue is obtained starting second year and the operational costs are calculated from second year. The tax depreciation however, starts from the first year and the after tax income for the first year is seen to be negative meaning a loss is incurred in the first year since investment have been made yet no revenue is earned. The cost of purchasing and operating new plane for 20 years is calculated as follows; The amount obtained after selling Mark 1 is assumed to be part of the cash used to purchase the new plane and is therefore, deducted from the initial cost. The total operating cost is the sum of annual operating costs incremented by 2.5% inflation rate every year for 20 years. There is no operating cost in the first year as the plane is delivered in the second year. Recommendations From the analysis done above and the calculation of Net Present Value of the two scenarios involving overhauling of Mark 1 plane and buying a new plane, the following recommendations are hereby presented. The investment that gives a higher Net Present Value is the best provided they have the same lives (Hill 26). Overhauling Mark 1 without purchasing new control system gave an NPV of $ 150,050 while if a new control system is purchased, the NPV is $365,942.10. From the two results, inclusion of a new control system gave a higher NPV and hence considering the two options, the best investment is to purchase a new control system for the plane. When annual costs are compared together with the option of purchasing new plane, the results show that the annual operational costs of the new plane including the purchasing cost are the lowest of the three with $1,203,161 annual cost. In this case, the profit obtained by selling Mark 1 is assumed to be part of the cost of purchasing the new plane. The new plane also comes with increased revenue generated and this would increase NPV. The two cases, however, have the disadvantage that no matter which option is taken, there would be no revenue for the first year. The new plane also has a longer life than overhauling Mark 1. The recommendation presented, therefore, is to sell Mark 1 now and purchase a new plane. 0 1 2 3 4 5 6 7 8 9 10 11 12 Revenue 0 1,400,000 1435000 1470875 1507647 1545338 1583971 1623571 1664160 1705764 1748408 1792118 Operating cost 0 -1210525 -1240788 -1271808 -1303603 -1336193 -1369598 -1403838 -1438934 -1474907 -1511780 -1549574 Tax Depreciation -117178 -200818 -143418 -102418 -73226 -73144 -73226 -36572 -27429 -18286 -9143 0 Pre-tax profit -117178 -11,343 50,794 96,649 130,818 136,001 141,148 183,161 197,797 212,571 227,485 242,544 Company Tax (35%) 41012.3 3970.05 -17777.9 -33827.2 -45786.2 -47600.3 -49401.6 -64106.3 -69229 -74399.8 -79619.9 -84890.4 After Tax Income -76165.7 -7372.95 33016.02 62821.96 85031.6 88400.62 91745.92 119054.6 128568.2 138171.1 147865.5 157653.6 Plus Depreciation 117178 200818 143418 102418 73226 73144 73226 36572 27429 18286 9143 0 Cash Flow -820000 41012.3 193445.1 176434 165240 158257.6 161544.6 164971.9 155626.6 155997.2 156457.1 157008.5 157653.6 PV of Cash Flow@11% -820000 36948.02 157004.3 129007 108848.7 93918.18 86368.35 79460.11 67530.5 60983.17 55101.75 49816.16 45063.84 Table 2 Calculation of NPV for overhauling Mark 1 plane without new control system 0 1 2 3 4 5 6 7 8 9 10 11 12 Revenue 0 1400000 1435000 1470875 1507647 1545338 1583971 1623571 1664160 1705764 1748408 1792118 Operating Cost 0 -1045500 -1071638 -1098428 -1125889 -1154036 -1182887 -1212459 -1242771 -1273840 -1305686 -1338328 Tax depreciation -202918 -347758 -248358 -177358 -126806 -126664 -126806 -63332 -47499 -31666 -15833 0 Pre-tax profit -202918 6742 115004.5 195088.6 254951.7 264637.7 274278.2 347779.3 373890.1 400257.8 426888.9 453790 Company Tax (35%) 71021.3 -2359.7 -40251.6 -68281 -89233.1 -92623.2 -95997.4 -121723 -130862 -140090 -149411 -158826 After Tax Income -131897 4382.3 74752.93 126807.6 165718.6 172014.5 178280.8 226056.6 243028.6 260167.6 277477.8 294963.5 Plus Depreciation 202918 347758 248358 177358 126806 126664 126806 63332 47499 31666 15833 0 Cash Flow -1420000 71021.3 352140.3 323110.9 304165.6 292524.6 298678.5 305086.8 289388.6 290527.6 291833.6 293310.8 294963.5 PV of Cash Flow @11% -1420000 63983.15 285805 236255.9 200363.3 173599.1 159685.7 146947.6 125573.4 113574.4 102779.3 93062.62 84312.6 Table 3 Calculation of NPV for overhauling Mark 1 plane with new control system Works Cited Hill, Robert Allan. Strategic Financial Management. 1st ed. Bookboon, 2009. U.S. Internal Revenue Service Publication 946, How to Depreciate Property. Washington, DC: U.S. Government Printing Office. Read More