Question

Stuart Delivery is a small company that transports business packages between New York and Chicago. It operates a fleet of small vans that moves packages to and from a central depot within each city and uses a common carrier to deliver the packages between the depots in the two cities. Stuart Delivery recently acquired approximately $6.6 million of cash capital from its owners, and its president, George Hay, is trying to identify the most profitable way to invest these funds.

  

Todd Payne, the company’s operations manager, believes that the money should be used to expand the fleet of city vans at a cost of $620,000. He argues that more vans would enable the company to expand its services into new markets, thereby increasing the revenue base. More specifically, he expects cash inflows to increase by $320,000 per year. The additional vans are expected to have an average useful life of four years and a combined salvage value of $107,000. Operating the vans will require additional working capital of $46,000, which will be recovered at the end of the fourth year.

  

In contrast, Oscar Vance, the company’s chief accountant, believes that the funds should be used to purchase large trucks to deliver the packages between the depots in the two cities. The conversion process would produce continuing improvement in operating savings and reduce cash outflows as follows:

  

Year 1			Year 2			Year 3			Year 4
	$157,000			$312,000			$397,000			$443,000

  

The large trucks are expected to cost $700,000 and to have a four-year useful life and a $77,000 salvage value. In addition to the purchase price of the trucks, up-front training costs are expected to amount to $18,000. Stuart Delivery’s management has established a 14 percent desired rate of return. (PV of $1 and PVA of $1) (Use appropriate factor(s) from the tables provided.)

  

Required

a.&b. Determine the net present value and present value index for each investment alternative

Answer 1

Solution a:

Computation of NPV - Investment in VAN (Alternative 1)
Particulars	Period	PV Factor	Amount	Present Value
Cash outflows:
Cost of VAN	0	1	$620,000.00	$620,000.00
Working capital	0	1	$46,000.00	$46,000.00
Present Value of Cash outflows (A)				$666,000.00
Cash Inflows
Annual increase in Cash Inflows:
Year 1	1	0.877192982	$320,000.00	$280,701.75
Year 2	2	0.769467528	$320,000.00	$246,229.61
Year 3	3	0.674971516	$320,000.00	$215,990.89
Year 4	4	0.592080277	$320,000.00	$189,465.69
Salvage Value	4	0.592080277	$107,000.00	$63,352.59
Recovery of Working capital	4	0.592080277	$46,000.00	$27,235.69
Present Value of Cash Inflows (B)				$1,022,976.22
Net Present Value (NPV) (B-A)				$356,976.22

Computation of NPV - Investment in Truck (Alternative 2)
Particulars	Period	PV Factor	Amount	Present Value
Cash outflows:
Cost of Truck	0	1	$700,000.00	$700,000.00
Upfront training cost	0	1	$18,000.00	$18,000.00
Present Value of Cash outflows (A)				$718,000.00
Cash Inflows
Annual increase in Cash Inflows:
Year 1	1	0.877192982	$157,000.00	$137,719.30
Year 2	2	0.769467528	$312,000.00	$240,073.87
Year 3	3	0.674971516	$397,000.00	$267,963.69
Year 4	4	0.592080277	$443,000.00	$262,291.56
Salvage Value	4	0.592080277	$77,000.00	$45,590.18
Present Value of Cash Inflows (B)				$953,638.60
Net Present Value (NPV) (B-A)				$235,638.60

Computation of Present Value Index
Particulars	Alternative 1 (Van)	Alternative 2 (Truck)
Present Value of Cash Inflows	$1,022,976.22	$953,638.60
Initial Cash Outflows	$666,000.00	$718,000.00
Present Value Index (PV of Cash Inflows / PV of cash outflows)	1.54	1.33