Question

Bilboa Freightlines, S.A., of Panama, has a small truck that it uses for intracity deliveries. The truck is worn out and must be either overhauled or replaced with a new truck. The company has assembled the following information: Present Truck New Truck Purchase cost new $ 31,000 $ 36,000 Remaining book value $ 24,000 - Overhaul needed now $ 23,000 - Annual cash operating costs $ 22,000 $ 19,500 Salvage value-now $ 5,000 - Salvage value-five years from now $ 20,000 $ 12,000 If the company keeps and overhauls its present delivery truck, then the truck will be usable for five more years. If a new truck is purchased, it will be used for five years, after which it will be traded in on another truck. The new truck would be diesel-operated, resulting in a substantial reduction in annual operating costs, as shown above. The company computes depreciation on a straight-line basis. All investment projects are evaluated using a 7% discount rate. Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables. Required: 1. What is the net present value of the “keep the old truck” alternative? 2. What is the net present value of the “purchase the new truck” alternative? 3. Should Bilboa Freightlines keep the old truck or purchase the new one?

Answer 1

Given data,

Particulars                                                                             present new

                                                                                             Truck ($) truck ($)

Purchase cost                                                                        $31000 $36000                   

Remaining book value                                                           $24000

Overhaul needed                                                                    $23000

Annual cash operating costs                                                   $22000 $19500

Salvage value - now                                                                $5000

Salvage value - 5 years from now                                            $20000 $10000

Discount rate - 7%

1. CALCULATION OF NET PRESENT VALUE TO KEEP THE OLD TRUCK:

Particulars                                                   Year Amount of 7% Present value of

                                                                                 Cash flows ($) Factor cash flows ($)

Overhaul needed                                         now $23000 1.000 ( $23000 )

Annual cash operating costs                        1-5 $22000 4.1 ( $90200 )

Salvage value of old truck                              5 $20000 0.713 $14260

Net present value of cash outflows to keep old truck                                        ( $98940 )

                      

2. CALCULATION OF NET PRESENT VALUE OF PURCHASE OF NEW TRUCK :

Initial investment                                          now $36000 1.000 ( $36000 )

Salvage value of old truck                            now $5000 1.000 $5000

Annual cash operating costs                        1-5 $19500 4.1 ( $79950 )

Salvage value of new truck                           5 $10000 0.713 $7130

Net present value of cash outflows of purchase of new truck                  ( $103820 )

Difference in the net present values of old truck and purchase of new truck is ($4880)

3. DECISION MAKING :

As the net present value of old truck is less than the purchase of new truck, it is beneficial for the Bilboa Freightlines, to keep the old truck