Question

Vaughn 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 $55,040. 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%. Click here to view PV table. (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.)

Answer 1

Answer a)

Calculation of cash payback period

Cash Payback period = Original cost of truck/ Net Annual cash inflow on account of cost savings

                                      = $ 55,040/ $ 8,600

                                      = 6.4 years

Therefore the payback period of the new truck is 6.4 years.

Decision: Since the payback period of truck (i.e. 6.4 years) is not less than 50% of estimated life of asset (i.e. 8 years X 50% = 4 years), the proposal to invest in new truck should not be accepted.

Answer b)

Calculation of Net present value

Net Present value = Present value of cash inflows – Present value of cash outflow

                                  = $ 65,034.90 - $ 55,040

                                  = $ 9,994.90 or $ 9,995 (rounded off)                                

                                  = $ 9,995

Therefore the Net Present value of investment in truck is $ 9,995. Since the NPV is negative, the project may be accepted.

Working Note:

Calculation of present value of cash inflows

Present value of cash inflows = (Annual cash savings X Present value of annuity of $ 1 at 8% for 8 years) + (Resale value of truck at the end of 8 years X Present value of $ 1 at 8% at the end of 8 years)

                                                      = ($ 8,600 X 5.74664) + ($ 28,900 X 0.54027)

                                                      = $ 49,421.10 + $ 15,613.80

                                                      = $ 65,034.90