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Economy Shipping

Economy Shipping Company (Abridged)

Question 1. What are the relevant cash flows under each of the two alternatives? And in what years do they occur?

Alternative 1: Rehabilitation of the Conway

We decided to divide this alternative in two parts. Part A is Rehabilitation without parts and Part B is Rehabilitation with parts.

Facts/Assumptions

• Conway’s additional useful life of 20 years.

• Book value of Conway: $39,500

• Market value of Conway: $25,000. This is the Opportunity Cost of not selling the Conway at year 0.

• Rehabilitation costs: $115,000. If spare parts are used, rehabilitation costs would be $71,500.

• Book value of spare parts if used on the Conway: $43,500.

• Market value of spare parts: $30,000. This is the Opportunity Cost of not selling the spare parts at year 0.

• Annual operating costs of Conway: $203,150

• No dismantling and scrapping costs at the end of useful life (This will be covered by the value of the scrap and used parts).

• Return of 10% after taxes.

• Tax rate: 48%

• Book cost of Conway, including rehabilitation costs, would be depreciated over a 20-year period.

• Depreciation according to the straight line method = (Cost - Residual value) / Useful life. For the rehabilitation alternative, residual value is zero at the end of year 20.

• ATCF(After-tax cash flow) will be calculated using the formula = Operating Costs after taxes plus Tax shields from depreciation.

Part A: Rehabilitation without parts

Depreciation =(39500+115000)/20 = $7725 per year.

Tax shield from depreciation = $7725*0.48 = $3708 per year

Here are the depreciation cash flows, the tax shields from depreciation and their present value:

|BOOK VALUE |$39,500.00 | | | |

| | | | | |

|YEAR |DEPRECIATION % |WRITE OFF AMNT |TAX SHIELD |PV OF TAX |

| | | | |SHIELD |

| | | | | |

|1 |5 |$1,975.00 |$948.00 |$861.82 |

|2 |5 |$1,975.00 |$948.00 |$783.47 |

|3 |5