PROBLEM 12-14A
Net Present Value; Total and Incremental Approaches
(LO1)
CHECK FIGURE
(1) $7,547 NPV in favor of purchasing new truck
San Jose Flights, 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. (Panama uses the U.S. dollar as its currency):
Present Truck / New TruckPurchase cost new...... / $28,000 / $42,000
Remaining book value...... / $18,000
Overhaul needed now...... / $9,500
Annual cash operating costs...... / $14,000 / $11,000
Salvage value—now...... / $10,000
Salvage value—10 years from now..... / $2,000 / $4,000
If the company keeps and overhauls its present delivery truck, then the truck will be usable for 10 more years. If a new truck is purchased, it will be used for 10 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 16% discount rate.
Required:
1. Should San Jose Flights, S.A. keep the old truck or purchase the new one? Use the total-cost approach to net present value in making your decision. Round to the nearest whole dollar.
2. Redo (1) above, this time using the incremental-cost approach.
1.The total-cost approach:
Item / Year(s) / Amount of Cash Flows / 16% Factor / Present Value of Cash FlowsPurchase the new truck:
Initial investment—new truck... / Now / $(42,000) / 1.000 / $(42,000)
Salvage of the old truck...... / Now / $10,000 / 1.000 / 10,000
Annual cash operating costs.... / 1-10 / $(11,000) / 4.833 / (53,163)
Salvage of the new truck...... / 10 / $4,000 / 0.227 / 908
Present value of the net cash outflows / $(84,255)
Keep the old truck:
Overhaul needed now...... / Now / $(9,500) / 1.000 / $(9,500)
Annual cash operating costs.... / 1-10 / $(14,000) / 4.833 / (67,662)
Salvage of the old truck...... / 10 / $2,000 / 0.227 / 454
Present value of the net cash outflows / $ (76,708)
Net present value of investing in the new truck rather than in the old truck / $7,547
The company should keep the old truck.
2.The incremental-cost approach:
Item / Year(s) / Amount of Cash Flows / 16% Factor / Present Value of Cash FlowsIncremental investment—new truck*. / Now / $(32,500) / 1.000 / $(32,500)
Salvage of the old truck...... / Now / $10,000 / 1.000 / 10,000
Savings in annual cash operating costs / 1-10 / $3,000 / 4.833 / 14,499
Difference in salvage value in 10 years / 10 / $2,000 / 0.227 / 454
Net present value in favor of keeping the old truck / $(7,547)
*$42,000 – $9,500 = $32,500. The $10,000 salvage value now of the old truck could also be deducted, leaving an incremental investment for the new truck of only $22,500.