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   $   49,000      $   68,500     
Remaining book value      34,000         -     
Overhaul needed now      14,500         -     
Annual cash operating costs      20,500         14,500     
Salvage value now      19,500         -     
Salvage value eight years from now      5,000         8,000     

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?

multiple choice
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

Solution 1a:

Total cost approach to Net Present Value - Bilboa Freighlines
Particulars	Now	1	2	3	4	5	6	7	8
Keep the old truck:
Overhaul needed now	-$14,500
Annual operating costs		-$20,500	-$20,500	-$20,500	-$20,500	-$20,500	-$20,500	-$20,500	-$20,500
Salvage value (Old)									$5,000
Total cash flows	-$14,500	-$20,500	-$20,500	-$20,500	-$20,500	-$20,500	-$20,500	-$20,500	-$15,500
Discount factor 16%	1.000	0.862	0.743	0.641	0.552	0.476	0.410	0.354	0.305
Present Value	-$14,500	-$17,671	-$15,232	-$13,141	-$11,316	-$9,758	-$8,405	-$7,257	-$4,728
Net Present Value	-$102,007
Purchase the New Truck:
Purchase new truck	-$68,500
Salvage value (old)	$19,500
Annual operating costs		-$14,500	-$14,500	-$14,500	-$14,500	-$14,500	-$14,500	-$14,500	-$14,500
Salvage value (new)									$8,000
Total cash flows	-$49,000	-$14,500	-$14,500	-$14,500	-$14,500	-$14,500	-$14,500	-$14,500	-$6,500
Discount factor 13%	1.000	0.862	0.743	0.641	0.552	0.476	0.410	0.354	0.305
Present Value	-$49,000	-$12,499	-$10,774	-$9,295	-$8,004	-$6,902	-$5,945	-$5,133	-$1,983
Net Present Value	-$109,534

Solution 1b:

Bilboa should keep the old truck

Solution 2:

Computation of NPV - Replacement decision - Bilboa Freightlines (Incremental Approach)
Particulars	Amount	Period	PV Factor	Present Value
Cash Outflows:
Initial investment in New Truck	$68,500	0	1	$68,500
Salvage value of old truck	-$19,500	0	1	-$19,500
Saving in overhaul cost	-$14,500	0	1	-$14,500
Present Value of Cash Outflows (A)				$34,500
Cash Inflows:
Annual savings in cash operating cost	$6,000	1-8	4.344	$26,064
Incremental salvage value	$3,000	8	0.305	$915
Present Value of Cash Inflows (B)				$26,979
Net Present Value (B-A)				-$7,521