Question

Bilboa Freightlines, S.A., of Panama, has a small truck that it uses for intracity deliveries. The truck is worn out and must be either overhauled or replaced with a new truck. The company has assembled the following information:

	Present Truck			New Truck
Purchase cost new	$	33,000		$	40,000
Remaining book value	$	24,000			-
Overhaul needed now	$	23,000			-
Annual cash operating costs	$	22,000		$	20,500
Salvage value-now	$	7,000			-
Salvage value-five years from now	$	25,000		$	14,000

     

If the company keeps and overhauls its present delivery truck, then the truck will be usable for five more years. If a new truck is purchased, it will be used for five years, after which it will be traded in on another truck. The new truck would be diesel-operated, resulting in a substantial reduction in annual operating costs, as shown above.

The company computes depreciation on a straight-line basis. All investment projects are evaluated using a 8% discount rate.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

    

Required:

1-a.	Use the total-cost approach to net present value. (Any cash outflows should be indicated by a minus sign. Round discount factor(s) to 3 decimal places.)

       

Answer 1

Answer a

Calculation of net present value for Present Truck

Particulars	Year	Cash flows ($)	PV factor @ 8%	Discounted Cash flows ($)
Overhaul needed now	0 or base year	(23,000)	1	(23,000)
Annual cash operating costs	1- 5 years	(22,000)	3.993	(87,846)
Salvage value or Terminal value	5 th year	25,000	0.681	17,025
Net present value				($93,821)

Answer b

Calculation of net present value for New Truck

Particulars	Year	Cash flows ($)	PV factor @ 8%	Discounted Cash flows ($)
Purchase cost	0 or base year	(40,000)	1	(40,000)
Salvage value of old truck	0 or base year	7,000	1	7,000
Annual cash operating costs	1- 5 years	(20,500)	3.993	(81,857)
Salvage value or Terminal value	5 th year	14,000	0.681	9,534
Net present value				($105,323)

Conclusion : Since npv under total cost approach for present truck is less than that of new truck , it is advisable to keep the present truck & incure the overhaul expense needed