In: Accounting
Speedy Pty Ltd operates a suburban delivery business. It is considering the replacement of a 2-ton van with a 3-ton van. Details of the respective vehicles are as follows:
2-ton truck
Remaining life3 years
Salvage Value now$4,000
Salvage Value in 3 years$0
Written down value now$6,600
Annual Depreciation for tax purposes$2,200
Annual net cash flows before tax$12,000
3-ton truck
Estimated life4 years
Salvage Value in 4 years$2,000
Annual Depreciation for tax purposes$6,000
Cost$24,000
Annual net cash flows before tax$20,000
The after-tax cost of capital 10%pa and the tax rate is 30%. Management is considering the following alternatives: Replace now or Replace in three years. Which alternative should be accepted? Explain your decision.
Ans. For 2 ton truck:
Annual net cash flows before tax = $ 12,000
Depreciation = $ 2,200
Net income before tax = Annual net cash flows - Depreciation
= $ 12,000 - $ 2,200
= $ 9800
Tax on net income = $ 9800 * 30%
= $ 2940
Annual net cash flows after tax = Net income before tax - Tax on net income + Depreciation
= $ 9800 - $ 2940 + $ 2,200
= $ 9060
Salvage Value in 3 years = $ 0
For 3 ton truck:
Cost = $ 24,000
Annual net cash flows before tax = $ 20,000
Depreciation = $ 6,000
Salvage Value in 4 years = $ 2,000
Salvage Value of 2 ton truck now = $ 4,000
Written down value of 2 ton truck now = $ 6,600
Loss on sale of 2 ton truck = $ 6,600 - $ 4000
= $ 2000
Tax benefit on loss on sale of 2 ton truck = $ 2000 *30%
= $ 600
Net salvage Value of 2 ton truck now = Salvage Value of 2 ton truck now + Tax benefit on loss on sale of 2 ton truck
= $ 4,000 + $ 600
= $ 4600
Net cash flow in year 0 on purchase of 3 ton truck initially = Cost - Net salvage Value of 2 ton truck now
= $ 24,000 - $ 4600
= $ 19400
Net income before tax = Annual net cash flows - Depreciation
= $ 20,000 - $ 6,000
= $ 14000
Tax on net income = $ 14000 * 30%
= $ 4200
Annual net cash flows after tax = Net income before tax - Tax on net income + Depreciation
= $ 14000 - $ 4200 + $ 6000
= $ 15800
Salvage Value in 4 years of 3 ton truck = $ 2,000
WDV of 3 ton truck at end of year 4 = $ 0
Gain on salvage value of 3 ton truck = $ 2,000 - $ 0
= $ 2000
Tax on gain = $ 2000 * 30%
= $ 600
Net salvage value of 3 ton truck at end of year 4 = $ 2000 - $ 600
= $ 1400
Decision : Management should replace the truck now because NPV of replacing now is $ 31,639.04 whereas NPV of replacing after 3 years is $ 22,530.41. So, replacing the truck now will result in more benefit to the company.