Question

Consider the following project data: A Shs 4 million feasibility study will be conducted at t =0. If the study indicates potential, the firm will spend Shs 20 million at t= 1 to build a prototype. The best estimate is that there is an 80% chance that the study will indicate potential and 20% chance that it will not. If reception of the prototype is good the firm will spend Sh. 700 million to build a production plant at t=2. The best estimate is that there is a 70% chance that the prototypes’ reception will be poor. If the plant is built, there’s a 60% chance of a t=3 cash inflow of Shs 600 million and a 40% chance of Shs 300 million cash inflow. If the inflow at t=3 is Shs 600 million, there are 30% and 70% chances of Shs 320 million and Shs 180 million inflows respectively at t=4. If the inflow at t=3 is Shs 300 million, there are 80% and 20% chances of Shs 420 million and Shs 280 million inflows respectively at t=4. The plant has a salvage value of Shs 100 million at t=5.

If the appropriate cost of capital is 14% what is the project’s expected NPV?

Answer 1

solution :

given that Rundle Freight Company owns a truck that cost $33,000.

also given that Currently, the truck’s book value is $27,000, and its expected remaining useful life is five years

mentioned in gi ven indormation that

Rundle has the opportunity to purchase for $28,000 a replacement truck that is extremely fuel efficient. Fuel cost for the old truck is expected to be $7,000 per year more than fuel cost for the new truck.

some other given information The old truck is paid for but, in spite of being in good condition, can be sold for only $16,000.

Calculating the total relevant costs:

	retaining truck	replacing truck
cost of the new truck	$-	$28000
additional fuel cost (5*7000)	$35000	$-
oppurtunity cost	$16000	$-
total cost	$51000	$28000

final decision of retaining old truck :

the purchase cost of ol;d truck and book value are irrelevant

they are sunk cost

therefore they should not be considered

the comparision cost of replacing and retaining truck are given above

from the above table

the company should replace the old truck as it would cost $28000 in replacement as against the cost of reraining truck of $51000