1. **Problem Statement:** TelCo must decide whether to replace an old computer with a new one. We need to calculate: a. The net investment required for the new system considering the ITC and sale of the old computer. b. The incremental operating cash flows from the new system. c. Whether TelCo should purchase the new computer based on its salvage value and cash flows. 2. **Given Data:** - New computer cost = 1000 (in $000) - ITC = 15% of new computer cost - Old computer sale price = 450 - Old computer original cost = 1250 - Old computer age = 3 years - Depreciable life = 5 years - Tax rate = 35% - Cost of capital = 12% - Depreciation method = straight-line - Net before-tax cost savings (in $000): Year 1=350, Year 2=350, Year 3=300, Year 4=300, Year 5=300 - Salvage value of new computer at year 5 = 100 3. **Step a: Calculate Net Investment** - ITC amount = $1000 \times 0.15 = 150$ - Book value of old computer after 3 years depreciation: $$\text{Annual depreciation} = \frac{1250}{5} = 250$$ $$\text{Accumulated depreciation} = 250 \times 3 = 750$$ $$\text{Book value} = 1250 - 750 = 500$$ - Tax on sale of old computer: $$\text{Gain} = 450 - 500 = -50 \text{ (loss)}$$ Since it is a loss, tax shield = $50 \times 0.35 = 17.5$ - Net proceeds from sale = Sale price + tax shield = 450 + 17.5 = 467.5$ - Net investment = Cost of new computer - ITC - Net proceeds from sale $$= 1000 - 150 - 467.5 = 382.5$$ 4. **Step b: Calculate Incremental Operating Cash Flows** - Depreciation on new computer: $$\frac{1000}{5} = 200 \text{ per year}$$ - Incremental before-tax savings given for each year. - Tax savings from depreciation = Depreciation \times Tax rate = 200 \times 0.35 = 70 - After-tax savings each year = Before-tax savings \times (1 - Tax rate) - Operating cash flow each year = After-tax savings + Depreciation tax shield Calculate for each year: Year 1: After-tax savings = 350 \times 0.65 = 227.5 Operating cash flow = 227.5 + 70 = 297.5 Year 2: Same as Year 1 = 297.5 Year 3: After-tax savings = 300 \times 0.65 = 195 Operating cash flow = 195 + 70 = 265 Year 4: Same as Year 3 = 265 Year 5: Same as Year 3 = 265 5. **Step c: Should TelCo purchase the new computer?** - Add salvage value after tax at year 5: Tax on salvage value = (100 - 0) \times 0.35 = 35 After-tax salvage value = 100 - 35 = 65 - Total cash flow at year 5 = Operating cash flow + after-tax salvage value = 265 + 65 = 330 - Calculate Net Present Value (NPV): $$NPV = -382.5 + \sum_{t=1}^4 \frac{CF_t}{(1+0.12)^t} + \frac{CF_5}{(1+0.12)^5}$$ Where $CF_t$ are the operating cash flows for years 1 to 4 and $CF_5$ includes salvage value. Calculate present values: Year 1: $\frac{297.5}{1.12} = 265.63$ Year 2: $\frac{297.5}{1.12^2} = 236.82$ Year 3: $\frac{265}{1.12^3} = 188.32$ Year 4: $\frac{265}{1.12^4} = 168.00$ Year 5: $\frac{330}{1.12^5} = 187.04$ Sum of PVs = 265.63 + 236.82 + 188.32 + 168.00 + 187.04 = 1045.81 NPV = 1045.81 - 382.5 = 663.31 Since NPV > 0, TelCo should purchase the new computer. **Final answer:** - Net investment required = 382.5 - Incremental operating cash flows (years 1-5) = 297.5, 297.5, 265, 265, 265 - NPV = 663.31 > 0, so purchase is recommended.