Question

Bilboa Freightlines, S.A. of Panama has a small truck that it uses for local deliveries. The truck is in bad repair and must be either overhauled or replaced with a new truck. The company has assembled the following information (Panama uses the U.S. dollar as its currency):

	Present Truck			New Truck
Purchase cost new	$	41,000		$	55,000
Remaining book value		26,000			-
Overhaul needed now		8,000			-
Annual cash operating costs		11,000			8,500
Salvage value now		14,000			-
Salvage value eight years from now		1,000			4,000

  

If the company keeps and overhauls its present delivery truck, then the truck will be usable for eight more years. If a new truck is purchased, it will be used for eight years, after which it will be traded in on another truck. The new truck would be diesel-fuelled, 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 16% discount rate.

    

Click here to view Exhibit 10-1 and Exhibit 10-2, to determine the appropriate discount factor(s) using tables.

  

Required:

1-a.	Determine the present value of net cash flows using the total-cost approach. (Negative amounts should be indicated with a minus sign. Round discount factor(s) to 3 decimal place.)

  
        

  

1-b.	Should Bilboa Freightlines keep the old truck or purchase the new one?
	Purchase the new truck Keep the old truck

2.	Using the incremental-cost approach, determine the net present value in favor of (or against) purchasing the new truck? (Negative amounts should be indicated with a minus sign. Round discount factor(s) to 3 decimal place.)

    
        

Answer 1

1.

Keep the old truck - total cost

Particular	Today	Year 1-7	Year 8
Overhaul cost	($8000)	$0	$0
Annual operating cost	$0	($11000)	($11000)
Salvage value	$0	$0	$1000
Total cash flow	($8000)	($11000)	($10000)
Discount factor @16%	1	4.038	0.305
Present value	($8000)	($44418)	($3050)
Net present value	($55468)

Purchase the new truck

Particular	Today	Year 1-7	Year 8
Purchase cost	($55000)
Annual operating cost	$0	($8500)	($8500)
Salvage value	$14000	$0	$4000
Total cash flow	($41000)	($8500)	($4500)
discount factor	1	4.038	0.305
Present value	($41000)	($34323)	($1372.5)
Net present value	($76695.5)

Since present value cost of keeping the old truck is less , hence he should keep the old truck.

2. Incremental cost approach.

Incremental Operating cost saving = $11000 - $8500 = $2500

Incremental salvage value = $4000 - $1000 = $3000

salvage value today = $14000

Purchase cost = $41000

Savings in overhaul cost today = $8000

Incremental NPV

Present value of saving @ 16% ($2500*4.343)	$10857.50
Add PV of incremental salvage value ($3000*0.305)	$915.00
Less purchase cost	($41000)
Add - overhaul cost saved	$8000
Add salvage value	$14000
NPV	($21227.50)

Since NPV of purchasing new truck is negative it Should not be purchased.

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