Question

Mr. Puffins Muffins is considering buying a new delivery truck.

Two options are being considered.

Option 1: The new truck will cost $95,000. It has an expected life of seven years, salvage value of $9,000 and will be depreciated using the straight line method.

At the end of the seven year the truck will be sold.

Option 2: Instead of paying the $95,000 all at once, a second option is to lease a truck for $25,000 down and $15,000 a year for 7 years. At the end of the lease a disposition fee of $800 will be paid.

With either option, the new truck is expected to generate cost savings of $20,000 in cash flows for each of the seven years of operations.

Mr. Puffins Muffins’ cost of capital is 12%.

The company uses NPV to evaluate capital projects.

Based on the NPV, which option should the company pursue and why?

Answer 1

	Option 1		Option 2
Year	Cash Outflow	Annual Inflow	Salvage Value	Total Cash flow	PVF @ 12%	PV		Cash Outflow	Annual Inflow	Total Cash flow	PV
	A	B	C	D=A+B+C	F	G=D*F		H	I	J=H+I	K=J*F
-	-95,000			-95,000	1.000	-95,000		-25,000		-25,000	-25,000
1		20,000		20,000	0.893	17,857		-15,000	20,000	5,000	4,464
2		20,000		20,000	0.797	15,944		-15,000	20,000	5,000	3,986
3		20,000		20,000	0.712	14,236		-15,000	20,000	5,000	3,559
4		20,000		20,000	0.636	12,710		-15,000	20,000	5,000	3,178
5		20,000		20,000	0.567	11,349		-15,000	20,000	5,000	2,837
6		20,000		20,000	0.507	10,133		-15,000	20,000	5,000	2,533
7		20,000	9,000	29,000	0.452	13,118		-15,800	20,000	4,200	1,900
					NPV (Sum of G)	346				NPV (Sum of K)	-2,543

As we can see NPV is positive in Option A, hence it is preferred.

Depreciation is not used as tax rate is not given hence there will be no tax savings.

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