Question

Linkin Corporation is considering purchasing a new delivery truck. The truck has many advantages over the company’s current truck (not the least of which is that it runs). The new truck would cost $55,200. Because of the increased capacity, reduced maintenance costs, and increased fuel economy, the new truck is expected to generate cost savings of $8,600. At the end of 8 years the company will sell the truck for an estimated $28,900. Traditionally the company has used a rule of thumb that a proposal should not be accepted unless it has a payback period that is less than 50% of the asset’s estimated useful life. Larry Newton, a new manager, has suggested that the company should not rely solely on the payback approach, but should also employ the net present value method when evaluating new projects. The company’s cost of capital is 8%.

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(a)

Compute the cash payback period and net present value of the proposed investment. (If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round answer for present value to 0 decimal places, e.g. 125. Round answer for Payback period to 1 decimal place, e.g. 10.5. For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

Cash payback period ?

Net Present Value ?

Answer 1

(a)-Cash payback period

Cash payback period = Initial Investment / Annual Cash Inflow

= $55,200 / $8,600

= 6.4 Years

“Cash payback period = 6.4 Years”

(b)-Net Present Value (NPV) of the Project

Year	Annual Cash Flow ($)	Present Value factor at 8%	Present Value of Cash Flow ($)
1	8,600	0.92593	7,963
2	8,600	0.85734	7,373
3	8,600	0.79383	6,827
4	8,600	0.73503	6,321
5	8,600	0.68058	5,853
6	8,600	0.63017	5,419
7	8,600	0.58349	5,018
8	37,500 [$8,600 + $28,900]	0.54027	20,260
TOTAL			65,035

Net Present Value (NPV) = Present Value of annual cash inflows – Initial Investment

= $65,035 - $55,200

= $9,835

“Net Present Value (NPV) of the Project = $9,835”

DECISION

The company has not met the company’s cash payback criteria. The company’s expected payback period is less than 50% of its useful life (Which means less than 4 Years) and the calculated payback period is 6.4 Years) which exceeds the company’s expectation. However, the company has met the net present value criteria since the NPV is positive $9,835.

NOTE    

The Formula for calculating the Present Value Factor is [1/(1 + r)ⁿ], Where “r” is the Discount/Interest Rate and “n” is the number of years.