New Economy Transport

867 Words Sep 29th, 2012 4 Pages
NEW ECONOMY TRANSPORT

Principles of Corporate Finance
7th Edition

Richard A. Brealey and Stewart C. Myers

This is an equipment replacement decision. The objective is to minimize the present value of future costs. But there are a few real-life complications.

• Some cash flows are stated in real terms, some in nominal terms. We will use a real discount rate for the real cash flows, a nominal rate for the nominal flows. The alternative is to convert all cash flows to real terms (using a real discount rate) or all to nominal (using a nominal rate).

• The new boat lasts longer (20 years) than the rehabilitated Vital Spark (15 years). Thus we calculate equivalent annual costs. The alternative analysis
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Operating costs and additional revenues are taken at mid-year.

11. Long-term expected inflation is 3%.

12. Using a NETCO “risk premium” of 10% and the 6% T-bond rate, the nominal opportunity cost of capital for NETCO is 16%.

13. Using the assumed long-term inflation rate of 3%, the real opportunity cost of capital for NETCO is:

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Analysis

Table 1 tabulates cash flows based on these assumptions.

Table 2 shows equivalent annual cost. The rehabilitated Vital Spark wins, but its margin over the new boat is small. Perhaps the new boat 's other attributes (better new accommodations, higher abandonment value[1]) should carry the day.

Table 3 shows a present-value analysis with a terminal value for the new boat entered at year 16. The new boat is slightly more expensive than the rehabilitated Vital Spark.

The spreadsheet used to generate the tables is attached.

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|Table 1: NEW ECONOMY CASE. CASH FLOWS AND TIMING |
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