Question

Example 3-7: Jeremy Pruitt Ltd is considering the replacement of a delivery truck. The current truck could last for three more years. Operating costs are 5000 per year. We are currently depreciating it at 4000 per year. We could sell it at the end of the three years for 2000 with a book value of zero. If we purchase the new truck for 32000 we could use three year MACRS. We could sell the old truck now for 7000. Operating costs would drop to 1000 per year. We can sell the new truck for 15000 at the end of the third year. The tax rate is 40%. The WACC is 10%. Should we replace the truck?

Answer 1

	0	1	2	3
Savings in operating costs (5000-1000)		4000	4000	4000
Incremental depreciation:
Depreciation on the new truck		10666	14224	4739
Depreciation on the old truck		4000	4000	4000
Incremental depreciation		6666	10224	739
Incremental NOI		-2666	-6224	3261
Tax at 40%		-1066	-2490	1304
Incremental NOPAT		-1599	-3734	1956
Add: Incremental depreciation		6666	10224	739
Incremental OCF		5066	6490	2696
Capital expenditure:
Cost of new truck	32000
Less: After tax salvage value of old truck = 7000+(12000-7000)*40% =	9000
Net initial investment	23000
Incremental terminal salvage value:
After tax salvage value of new truck = 15000-(15000-2371)*40% =				9948
Less: After tax salvage value lost on old truck = 2000*(1-40%) =				1200
Incremental net residual value				8748
After tax annual cash flows	-23000	5066	6490	11444
PVIF at 10%	1	0.90909	0.82645	0.75131
PV at 10%	-23000	4606	5363	8598
NPV	-4433
CONCLUSION:
As the NPV of the replacement project is negative, the truck should not be replaced.