Question

The Sorensen Supplies Company recently purchased a new delivery truck. The initial cash outflow for the new truck is $20,500, and it is expected to generate after-tax cash flows of $5,725 per year. The truck has a 5-year expected life. The expected year-end abandonment values (after-tax salvage values) for the truck are given below. The company's WACC is 8%.

Year	Annual After-Tax Cash Flow		Abandonment Value
0	($20,500)			-
1	5,725			$14,500
2	5,725			12,000
3	5,725			9,000
4	5,725			4,000
5	5,725			0

1. What is the truck's optimal economic life? Round your answer to the nearest whole number.

      year(s)

2. Would the introduction of abandonment values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project?

   -Select-YesNo

Answer 1

Steps to computation

To find the net present value of project with options of abandonment at various time periods the formula to be used is :

NPV = Pv of cashflow + Pv of Abandonment Value - Initial investment

In the first table, we compute the present value of the cashflows discounted @ 8% (WACC)

In the second table we consider the 5 options: if sold at end of YEAR 1,2 , 3, 4 or 5.

IF SOLD AT YEAR 1

PV of Cashflow after tax of Year 1 = 5300.93

PV of Abandonment Value of Year 1 = 13425.93

Initial outlay=20500

Hence NPV= 5300.93+13425.93-20500= -1773.15.

Similarly, we compute the NPV for all the other options. From the computations, we can observe that the option with highest NPV is if the asset is held for 5 years.Hence the optimum economic life of truck is 5 years.

From the computations, we can observe that on introduction of Abandonment Values, the NPV as well as the IRR of the project reduces.