Question

2. ABC Construction must replace a number of its concrete mixer trucks with new trucks. It has received two bids and has evaluated closely the performance characteristics of the various trucks. The truck A, which costs $84.000, is top-of-the-line equipment. The truck has a life of eight years, assuming that the engine is rebuilt in the fifth year. Maintenance costs of $2,500 a year are expected in the first four years, followed by total maintenance and rebuilding costs of $12,000 in the fifth year. During the last three years, maintenance costs are expected to be $4,000 a year. At the end of eight years, the truck will have an estimated scrap value of $10,000.

The trucks B cost $51,000 a truck. Maintenance costs for the truck will be higher. In the first year, they are expected to be S4,000, and this amount is expected to increase by $1,500 a year through the eighth year. In the fourth year, the engine will need to be rebuilt, and this will cost the company $18,000 in addition to maintenance costs in that year. At the end of eight years, the truck will have an estimated scrap value of $7,000.

a) Using MACRS (5-year property), estimate the after-tax cash flows related to the trucks? (Use Tax rate of 35%)

b) If ABC Construction's opportunity cost of funds is 10%, which truck should it accept?

c) If its opportunity cost were 15%, would your answer change?

d) At what opportunity cost will truck A and B be equal?

Answer 1

After Tax Salvage from Equipment Disposal = Salvage Value – Tax (Salvage Value – Book Value)

For both truck depreciation is fully charged so book value is 0.

Truck A = 10,000 - 0.35(10,000 - 0) = 6,500

Truck B = 7000 - 0.35(7,000 - 0) = 4550

a) Using MACRS (5-year property), estimate the after-tax cash flows related to the trucks? (Use Tax rate of 35%)

Please refer below table

b) If ABC Construction's opportunity cost of funds is 10%, which truck should it accept?

Truck B should be accepted as cash outflows are less there. Refer below table for further detail.

Truck A	0	1	2	3	4	5	6	7	8
Initial Cost	84000
Maintinance and or Rebuilt Cost		2500	2500	2500	2500	12000	4000	4000	4000
MACRS 5 Year Property Depreciation Rate		20	32	19.2	11.52	11.52	5.76
Depreciation		16800	26880	16128	9676.8	9676.8	4838.4
Total Cost	84000	19300	29380	18628	12177	21677	8838.4	4000	4000
Tax Rate 35%
Saving Due to Tax		6755	10283	6520	4261.9	7586.9	3093.4	1400	1400
Net Outflow	84000	12545	19097	12108	7914.9	14090	5745	2600	2600
After Tax Salvage from Equipment Disposal									6500
Outflow after Salvage Value	84000	12545	19097	12108	7914.9	14090	5745	2600	-3900
Opportunity Cost of funds 10%
PV	84000	11404.5	15783	9097	5406	8748.7	3242.9	1334	-1819
Sum of PV	1,37,197
Truck B	0	1	2	3	4	5	6	7	8
Initial Cost	51000
Maintinance and or Rebuilt Cost		4000	5500	7000	26500	10000	11500	13000	14500
MACRS 5 Year Property Depreciation Rate		20	32	19.2	11.52	11.52	5.76
Depreciation		10200	16320	9792	5875.2	5875.2	2937.6
Total Cost	51000	14200	21820	16792	32375	15875	14438	13000	14500
Tax Rate 35%
Saving Due to Tax		4970	7637	5877	11331	5556.3	5053.2	4550	5075
Net Outflow	51000	9230	14183	10915	21044	10319	9384.4	8450	9425
After Tax Salvage from Equipment Disposal									4550
Outflow after Salvage Value	51000	9230	14183	10915	21044	10319	9384.4	8450	4875
Opportunity Cost of funds 10%
PV	51000	8390.91	11721	8200	14373	6407.2	5297.3	4336	2274
Sum of PV	1,12,001

c) If its opportunity cost were 15%, would your answer change?

No still we would go for truck B as outflows are less there. Refer below table.

Truck A	0	1	2	3	4	5	6	7	8
Initial Cost	84000
Maintinance and or Rebuilt Cost		2500	2500	2500	2500	12000	4000	4000	4000
MACRS 5 Year Property Depreciation Rate		20	32	19.2	11.52	11.52	5.76
Depreciation		16800	26880	16128	9676.8	9676.8	4838.4
Total Cost	84000	19300	29380	18628	12176.8	21676.8	8838.4	4000	4000
Tax Rate 35%
Saving Due to Tax		6755	10283	6519.8	4261.88	7586.88	3093.44	1400	1400
Net Outflow	84000	12545	19097	12108.2	7914.92	14089.92	5744.96	2600	2600
After Tax Salvage from Equipment Disposal									6500
Outflow after Salvage Value	84000	12545	19097	12108.2	7914.92	14089.92	5744.96	2600	-3900
Opportunity Cost of funds 10%
PV	84000	10909	14440	7961	4525	7005	2484	977	-1275
Sum of PV	1,31,027
Truck B	0	1	2	3	4	5	6	7	8
Initial Cost	51000
Maintinance and or Rebuilt Cost		4000	5500	7000	26500	10000	11500	13000	14500
MACRS 5 Year Property Depreciation Rate		20	32	19.2	11.52	11.52	5.76
Depreciation		10200	16320	9792	5875.2	5875.2	2937.6
Total Cost	51000	14200	21820	16792	32375.2	15875.2	14437.6	13000	14500
Tax Rate 35%
Saving Due to Tax		4970	7637	5877.2	11331.32	5556.32	5053.16	4550	5075
Net Outflow	51000	9230	14183	10914.8	21043.88	10318.88	9384.44	8450	9425
After Tax Salvage from Equipment Disposal									4550
Outflow after Salvage Value	51000	9230	14183	10914.8	21043.88	10318.88	9384.44	8450	4875
Opportunity Cost of funds 10%
PV	51000	8026	10724	7177	12032	5130	4057	3177	1594
Sum of PV	1,02,917

d) At what opportunity cost will truck A and B be equal?

Truck A and B be equal can't be equal at any opportunity cost as initial investment is high in truck A and PV won't match to truck B even at discounting at one or less than one.

Thanks and have a good day,