Question

1. H Corp recently purchased a new delivery truck. The new truck has a cost of $56250 and is expected to generate after tax cash flows including depreciation of $15625 per year. The truck has a five year expected life. The expected year end abandonment Values (Salvage Value after tax adjustments) for the truck are given below. The company’s cost of capital is 11%

Year                 Annual operating CF     Abandonment Value

0                      (56250)                         ----

1                      15,625                          43750

2                      15,625                          35000

3                      15,625                          27500

4                      15,625                          12500

5                      15,625                          0

Should the truck operate until the end of its 5 year life? If not what is the optimal economic life of the truck?

A) 1 year

B) 2 years

C) 3 years

D) 4 years

E) 5 years

Answer 1

Ans) c) 3 Years

We need to find which alternative will have highest Equivalent annual benefit

Statement showing Equivalent annual benefit if machine is kept for 1 year

Particulars	0	1	Total
Cost	-56250
Annaul operating Cash flow		15625
Abandonment Value		43750
Total cash flow	-56250	59375
PVIF @ 11%	1.0000	0.9009
PV	-56250	53490.99	-2759.01
PVIF(11%,1)			0.9009
Equivalent Annual Benefit			-3062.5

Thus Equivalent Annual Benefit = -3062.5 $

Statement showing Equivalent annual benefit if machine is kept for 2 year

Particulars	0	1	2	Total
Cost	-56250
Annaul operating Cash flow		15625	15625
Abandonment Value			35000
Total cash flow	-56250	15625	50625
PVIF @ 11%	1.0000	0.9009	0.8116
PV	-56250	14076.58	41088.39	-1085.04
PVIF(11%,1)				1.7125
Equivalent Annual Benefit				-633.59

Thus Equivalent Annual Benefit = -633.59 $

Statement showing Equivalent annual benefit if machine is kept for 3 year

Particulars	0	1	2	3	Total
Cost	-56250
Annaul operating Cash flow		15625	15625	15625
Abandonment Value				27500
Total cash flow	-56250	15625	15625	43125
PVIF @ 11%	1.0000	0.9009	0.8116	0.7312
PV	-56250.00	14076.58	12681.60	31532.63	2040.81
PVIF(11%,3)					2.4437
Equivalent Annual Benefit					835.12

Thus Equivalent Annual Benefit = 835.12 $

Statement showing Equivalent annual benefit if machine is kept for 4 year

Particulars	0	1	2	3	4	Total
Cost	-56250
Annaul operating Cash flow		15625	15625	15625	15625
Abandonment Value					12500
Total cash flow	-56250	15625	15625	15625	28125
PVIF @ 11%	1.0000	0.9009	0.8116	0.7312	0.6587
PV	-56250.00	14076.58	12681.60	11424.87	18526.81	459.85
PVIF(11%,4)						3.1024
Equivalent Annual Benefit						148.22

Thus Equivalent Annual Benefit = 148.22 $

Statement showing Equivalent annual benefit if machine is kept for 5 year

Particulars	0	1	2	3	4	5	Total
Cost	-56250
Annaul operating Cash flow		15625	15625	15625	15625	15625
Abandonment Value
Total cash flow	-56250	15625	15625	15625	15625	15625
PVIF @ 11%	1.0000	0.9009	0.8116	0.7312	0.6587	0.5935
PV	-56250.00	14076.58	12681.60	11424.87	10292.67	9272.68	1498.39
PVIF(11%,5)							3.6959
Equivalent Annual Benefit							405.42

Thus Equivalent Annual Benefit = 405.42 $

Thus in year 3  Equivalent Annual Benefit is highest and hence 3 years is economical life of machine

Note :  Equivalent Annual Benefit = Total of PV / PVIFA