Question

Finning Corporation is considering purchasing a new trailer for its operations for $60,000. The Manager has put together an estimate of anticipated financials:

Initial cost $60,000
Estimated useful life 8 years
Annual Depreciation $4,500

Net annual cash inflows $10,990
Net annual cash outflows $ 3,000

Overhaul costs (end of year 4) $5,990
Salvage value $12,000

Prior to moving forward with the purchase, the owner of the company looked at the analysis and realized that there were some intangible benefits that the Manager had not considered. Below are some additional items that the owner has factored into the analysis:

Additional annual net cash flows from repair work $3,010
Annual cost savings 750
Additional annual net cash flows from customer “goodwill” 970
Additional annual net cash flows resulting from quality 740
The company’s cost of capital is 9%.

Required:
a) Calculate the NPV based on the Manager’s initial projections and comment on whether the company should move forward with the purchase
b) Calculate the NPV factoring in the additional intangible benefits and comment on whether the company should move forward with the purchase
c) Calculate the profitability index for both options and discuss the difference between the profitability index and NPV.

Answer 1

A.

Year	0	1	2	3	4	5	6	7	8
Initial Cost	-60000	0	0	0	0	0	0	0	0
Annual Cash Inflow	0	10990	10990	10990	10990	10990	10990	10990	10990
Annual Cash Outflow	0	-3000	-3000	-3000	-3000	-3000	-3000	-3000	-3000
Overhaul Costs	0	0	0	0	-5990	0	0	0	0
Salvage Value	0	0	0	0	0	0	0	0	12000
Free Cash Flow	-60000	7990	7990	7990	2000	7990	7990	7990	19990
PVF@9%	1	0.917431	0.84168	0.772183	0.708425	0.649931	0.596267	0.547034	0.501866
Total									-13997.9

B.

Year	0	1	2	3	4	5	6	7	8
Initial Cost	-60000	0	0	0	0	0	0	0	0
Annual Cash Inflow	0	10990	10990	10990	10990	10990	10990	10990	10990
Annual Cash Outflow	0	-3000	-3000	-3000	-3000	-3000	-3000	-3000	-3000
Overhaul Costs	0	0	0	0	-5990	0	0	0	0
Salvage Value	0	0	0	0	0	0	0	0	12000
Repair work savings	0	3010	3010	3010	3010	3010	3010	3010	3010
Annual Cost Savings	0	750	750	750	750	750	750	750	750
Goodwill cashflow	0	970	970	970	970	970	970	970	970
Quality Cashflow	0	740	740	740	740	740	740	740	740
Free Cash Flow	-60000	13460	13460	13460	7470	13460	13460	13460	25460
PVF@9%	1	0.917431	0.84168	0.772183	0.708425	0.649931	0.596267	0.547034	0.501866
Total									16277.59

C.
Profitability Index =PV of Future Cashflows/ Initial Investment
Profitability Index with more than 1 is favorable as it depicts positive NPV.
NPV is calculated in amount but profitability index is determined in Times.Both reflect present value and its impact

Scenario A = (46002 / 60,000) / 60,000 = 0.77
Scenario B = (60000+16277 ) / 60,000 = 1.27