Question

(Related to Checkpoint​ 12.2)  ​(Replacement project cash​ flows)  ​Madrano's Wholesale Fruit Company located in​ McAllen, Texas is considering the purchase of a new fleet of tractors to be used in the delivery of fruits and vegetables grown in the Rio Grande Valley of Texas. If it goes through with the​ purchase, it will spend ​$320,000 on eight rigs. The new trucks will be kept for 5 ​years, during which time they will be depreciated toward a ​$41,000 salvage value using​ straight-line depreciation. The rigs are expected to have a market value in 5 years equal to their salvage value. The new tractors will be used to replace the​ company's older fleet of eight trucks which are fully depreciated but can be sold for an estimated ​$18,000 ​(because the tractors have a current book value of​ zero, the selling price is fully taxable at the​ firm's 25 percent tax​ rate). The existing tractor fleet is expected to be useable for 5 more years after which time they will have no salvage value. The existing fleet of tractors uses ​$205,000 per year in diesel​ fuel, whereas the​ new, more efficient fleet will use only ​$170,000.

In​ addition, the new fleet will be covered under​ warranty, so the maintenance costs per year are expected to be only ​$13,000 compared to ​$33,000 for the existing fleet.

a.  What are the differential operating cash flow savings per year during years 1 through 5 for the new​ fleet?

b.  What is the initial cash outlay required to replace the existing fleet with the newer​ tractors?

c.  What does the timeline for the replacement project cash flows for years 0 through 5 look​ like?

d.  If Madrano requires a discount rate of 7 percent for new​ investments, should the fleet be​ replaced?

Answer 1

Answer (a)

Particulars	Old Fleet	New Fleet	Saving
Fuel Cost per year	$2,05,000	$1,70,000	$ 35,000
Maintenance Cost per year	$ 33,000	$ 13,000	$ 20,000
Total	$ 2,38,000	$ 1,83,000	$ 55,000

Therefore differential operating cash outflow savings per year during years 1 through 5 for the new fleet is $ 55,000

Answer (b)

Initial Cash Outlay required to replace the existing machine with new tractors will be computed as below:

= Gross Investment in New Tractors - (Sale Proceeds realised from sale of old fleet - Tax Payable)

= $3,20,000 - ($18000 - [25% * $18000])

= $ 3,20,000 - ( $ 13,500)

= $ 3,06,500

Answer (c)

Timeline for the replacement project cash flows for years 0 through 5 look​ like as below :

Particulars	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Initial Outlay	- $ 3,06,500	0	0	0	0	0
Savings in operation Expenses		$ 55,000	$ 55,000	$ 55,000	$ 55,000	$ 55,000
Less : Tax payable on savings @ 25%		$ 13,750	$ 13,750	$ 13,750	$ 13,750	$ 13,750
Add: Salvage Value of New Fleet						$ 41,000
Less: Tax Payable on Dispossal						$ 10,250
Add: Depreciation		$ 55,800	$ 55,800	$ 55,800	$ 55,800	$ 55,800
Net Cash Flow	- $ 3,06,500	$ 97,050	$ 97,050	$ 97,050	$ 97,050	$1,27,800

Answer (d)

To evaluate the project viability using a discount rate of 7% we need to calculate the NPV of the above computed cash flows. If, it is positive then only the new fleet be acquired and old fleet be discarded.

NPV = - $ 3,06,500 + $97,050/(1.07) + $97,050/(1.07)2 + $97,050/(1.07)3+ $97,050/(1.07)4 + $1,27,800 / 1.07)5

= $ 1,05,933.16

Since, the NPV is positive the ​Madrano's Wholesale Fruit Company located in​ McAllen should purchase the new fllet and doscard the old fleet

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