Question

The Sorensen Supplies Company recently purchased a new delivery truck. The initial cash outflow for the new truck is $24,000, and it is expected to generate after-tax cash flows of $6,575 per year. The truck has a 5-year expected life. The expected year-end abandonment values (after-tax salvage values) for the truck are given below. The company's WACC is 8%.

Year	Annual After-Tax Cash Flow		Abandonment Value
0	($24,000)			-
1	6,575			$19,000
2	6,575			16,500
3	6,575			12,500
4	6,575			8,500
5	6,575			0

1. What is the truck's optimal economic life? Round your answer to the nearest whole number.

      year(s)

2. Would the introduction of abandonment values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project?

   -Select-YesNoItem 2

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Answer 1

a).

We need to calculate NPV at the end of each year.

NPV at the end of Year 1= -24000+6575/1.08+19000/1.08= -$319.44

NPV at the end of Year 2= -24000+6575/1.08+6575/1.08^2+16500/1.08^2= $1871.06

NPV at the end of Year 3= -24000+6575/1.08+6575/1.08^2+6575/1.08^3+12500/1.08^3= $2867.32

NPV at the end of Year 4= -24000+6575/1.08+6575/1.08^2+6575/1.08^3+6575/1.08^4+8500/1.08^4= $4024.99

NPV at the end of Year 5= -24000+6575/1.08+6575/1.08^2+6575/1.08^3+6575/1.08^4+6575/1.08^5+0/1.08^5= $2252.07

So, the truck's optimal economic life is until 4 years.

b).

No.

The abandonment option value will only increase the expected NPV and IRR, because the lowest value that an option will have is $0. (when we choose not to exercise the option).