Question

Distance Trucking is considering replacing an existing semi-trailer truck with a more modern long-haul vehicle. The existing truck was purchased 5 years ago at a cost of $180,000 and is being depreciated over its useful life of 10 years at which point it is estimated to have a residual trade in value of $30,000. The existing truck has 5 years of usable life remaining and can currently be sold for $70,000 net.

The new long-haul truck being considered will cost $230,000 plus $15,000 delivery from an interstate dealer. It will be depreciated over its useful life of 5 years having a residual value of $90,000 given it’s still a relatively new vehicle and provide the benefit of reducing cash operating costs by $45,000 per annum.

(Note: Ignore Tax Implications and assume operating cost savings are gained at year end each year)

REQUIRED

1. Based on a required return of 14 per cent cost of capital / time value of money, calculate the Net Present Value (Cost) of continuing to use the existing vehicle (option a – cash flows) versus purchasing the new vehicle (option b cash flows). As part of your answer interpret the meaning of the net present value / cost calculated. (Ignore tax implications. / show all working as part of your answer)

Additional information:

The present value of $1, ie. (1+r)^-n      Where: r = discount rate; n = number of periods until payment.

Discount rate (r) 14%	Periods (n)
	1	2	3	4	5
Present value of $1	0.877	0.769	0.675	0.592	0.519

2. Provide three other non-financial considerations other than Net Present Value / Cost that should be considered when evaluating the above investment proposal to purchase a more modern truck.   (100 words limit)

3. The general manager at Distance Trucking Ltd says she has heard that the data used in NPV calculations can be unreliable, especially estimates of future cash flows, and that alternative methods of assessing a capital investment would be more reliable. Discuss in your own words the limitations and advantages of NPV analysis over other capital evaluation techniques reviewed throughout the semester. (180 words limit)

Answer 1

The given problem relates to the replacement decision on the existing asset.
Net present value  is calculated by taking the difference between the present value of cash inflows and the present value of cash outflows over a period of time. The investment with a positive NPV will be considered. In case there are multiple projects, the project with a higher Net Present Value is more likely to be selected.

a.Calculation of Net present value of cashflows in the case of Distant trucking on account of replacing old truck or continuing with the existing one:

Option 1 - Cashflows - if the existing truck continued
	Year 1	Year 2	Year 3	Year 4	Year 5
	$	$	$	$	$
Operating expenses*	1,00,000	1,00,000	1,00,000	1,00,000	1,00,000
Residual value					30,000
	1,00,000	1,00,000	1,00,000	1,00,000	70,000
Discount factor @ 14%	1	1	1	1	1
Present value of cashflows	87,719	76,947	67,497	59,208	36,356
Net present value of cashflows	$ 3,27,727

* It is assumed that operating expenses is $ 100,000 per year.

Option 2 - Cashflows - if new truck purchased
Immediate cash outflows in Year 1
Purchase of New truck	245000
Sale value of old truck	70000
Immedite cashoutflows	175000
	Year 1	Year 2	Year 3	Year 4	Year 5
	$	$	$	$	$
Operating expenses*	55,000	55,000	55,000	55,000	55,000
Residual value					90,000
	55,000	55,000	55,000	55,000	-35,000
Discount factor @ 14%	1	1	1	1	1
Present value of cashflows	48,246	42,321	37,123	32,564	-18,178
Total cash outflows	$ 1,42,076
Add: Immediate cash outflows	$ 1,75,000
Net present value of cashflows	$ 3,17,076

* Operating expenses of $100,000 will come down by $ 45,000 if the new truck is used.

Summary:

Option 1 - If the existing truck used - Cash outflows - $ 3,27,727

Option 2 - If new truck purchased - Cash outflows -   $ 3,17,076

Net present value of the replacement will Long haul truck is $ 327727 - $ 317076 = $ 10651 ( positive )

Hence, purchasing of new truck is advisable.

b. Non financial considerations:

1.Long-haul routes are driven by the most experienced drivers because the trucks and cargo are valuable.

2. The statutory requirements for long haul trucks are more compared to semi trucks.

3. Long haul trucks have more space & capacity compared to semi trucks. Using of Long haul trucks with the load of Semi truck will increase the cost of operations.

c. Other capital evaluation techniques:

1.Payback Period.

2.Internal Rate of Return

3.Profitability Index

1. Payback period:

This method of capital evaluation results in understanding, how long it will take to get back the invested amount. Net present value do not provide the number of years in which the investment will be paid back to the entity. But Net present value gives us the benefits over costs in absolute number.

2. Internal Rate of Return: (IRR)

This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task.

IRR provides the result in % value whereas NPV provides the result in absolute number. NPV and IRR methods differ in the sense that the results regarding the choice of an asset under certain circumstances are mutually contradictory under two methods. In case of mutually exclusive investment projects, in certain situations, they may give contradictory results such that if the NPV method finds one proposal acceptable, IRR favors another. The difference could be due to size disparity problem, time disparity problem and unequal expected lives.

3. Profitability Index:

It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. Profitability Index do not provide the result in absolute numbers as against NPV method.