1. **Problem Statement:** TelCo is considering replacing an old computer with a new one costing 1,000,000. The new computer yields before-tax cost savings over 5 years: $350,000, $350,000, $300,000, $300,000, $300,000 respectively. The cost of capital is 12%, tax rate is 35%, and straight-line depreciation is used. The old computer cost 1,250,000, is 3 years old, depreciated over 5 years to zero salvage, and can be sold for 450,000. The new computer qualifies for a 15% investment tax credit (ITC). 2. **Part a: Calculate Net Investment Required** - Cost of new computer = 1,000,000 - ITC = 15% of 1,000,000 = 150,000 (tax credit reduces taxes) - Old computer original cost = 1,250,000 - Depreciation per year = $1,250,000 / 5 = 250,000 - Accumulated depreciation after 3 years = 3 × 250,000 = 750,000 - Book value of old computer = 1,250,000 - 750,000 = 500,000 - Sale price of old computer = 450,000 - Tax effect on sale = (Sale price - Book value) × Tax rate = (450,000 - 500,000) × 0.35 = -17,500 (a tax saving because of loss) Net investment = Cost of new computer - ITC - (Sale price of old computer - Tax effect on sale) $$\text{Net Investment} = 1,000,000 - 150,000 - (450,000 - (-17,500)) = 1,000,000 - 150,000 - 467,500 = 382,500$$ 3. **Part b: Estimate Incremental Operating Cash Flows** - Before-tax cost savings each year: $350,000, $350,000, $300,000, $300,000, $300,000 - Tax on savings = 35% - After-tax savings = Before-tax savings × (1 - Tax rate) Calculate for each year: Year 1 and 2: $350,000 \times (1 - 0.35) = 227,500$ Year 3 to 5: $300,000 \times (1 - 0.35) = 195,000$ - Depreciation expense per year for new computer = $1,000,000 / 5 = 200,000$ - Tax shield from depreciation = Depreciation × Tax rate = $200,000 \times 0.35 = 70,000$ - Incremental operating cash flow = After-tax savings + Depreciation tax shield Year 1 and 2: $227,500 + 70,000 = 297,500$ Year 3 to 5: $195,000 + 70,000 = 265,000$ 4. **Part c: Should TelCo purchase the new computer?** - Salvage value at end of 5 years = 100,000 - Book value at end of 5 years = 0 (fully depreciated) - Tax on salvage = (Salvage value - Book value) × Tax rate = 100,000 × 0.35 = 35,000 - After-tax salvage value = 100,000 - 35,000 = 65,000 - Calculate Net Present Value (NPV) of cash flows including initial investment and salvage value: Initial outflow = -382,500 Cash inflows years 1-2 = 297,500 each Cash inflows years 3-5 = 265,000 each Add after-tax salvage value at year 5 = 65,000 Using discount rate 12%, NPV = $$-382,500 + \frac{297,500}{(1+0.12)^1} + \frac{297,500}{(1+0.12)^2} + \frac{265,000}{(1+0.12)^3} + \frac{265,000}{(1+0.12)^4} + \frac{265,000 + 65,000}{(1+0.12)^5}$$ Calculate each term: Year 1: $\frac{297,500}{1.12} = 265,625$ Year 2: $\frac{297,500}{1.2544} = 237,086$ Year 3: $\frac{265,000}{1.4049} = 188,592$ Year 4: $\frac{265,000}{1.5735} = 168,448$ Year 5: $\frac{330,000}{1.7623} = 187,224$ Sum of inflows = 265,625 + 237,086 + 188,592 + 168,448 + 187,224 = 1,047,975 NPV = 1,047,975 - 382,500 = 665,475 Since NPV > 0, TelCo should purchase the new computer.