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 $ 25,000 $ 30,000 Remaining book value $ 11,000 - Overhaul needed now $ 11,000 - Annual cash operating costs $ 12,500 $ 10,000 Salvage value-now $ 5,000 - Salvage value-five years from now $ 4,000 $ 5,000 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 11% discount rate. Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables. Required: 1. What is the net present value of the “keep the old truck” alternative? 2. What is the net present value of the “purchase the new truck” alternative? 3. Should Bilboa Freightlines keep the old truck or purchase the new one?

Answer 1

1.Net Present Value = Present Value of Cash Inflows – Present Value of Cash Outflows

Net present value of Cash Outflows of ‘keep the old truck’ alternative = 11,000 + 12,500*PVAF(11%, 5 years) - 4,000*PVF(11%, 5 years)

= 11,000 + 12,500*3.696 - 4,000*0.593

= $54,828

2. Net present value of Cash Outflows of ‘purchase the new truck’ alternative = (30,000 – 5,000)+10,000*PVAF(11%, 5 years) – 5,000*PVF(11%, 5 years)

= 25,000 + 10,000*3.696 – 5,000*0.593

= $58,995

Note: 5,000 will be recovered from the sale of old truck if the new truck is purchased, hence deducted.

3. Bilboa Freightlines should keep the old truck since present value of cash outflows is lower in this case.