Question

Five years ago, Kennedy Trucking Company was considering the purchase of 60 new diesel trucks that were 15% more fuel-efficient than the ones the firm was using. Mr. Hoffman, the president, had found that the company uses an average of 10million gallons of diesel fuel per year at a price of $1.25 per gallon. If he can cut fuel consumption by 15%, he will save $1,875,000 per year (1,500,000 gallons times $1.25). Mr. Hoffman assumed that the price of diesel fuel is an external market force that he cannot control and that any increase costs of fuel will be passed on to the shipper through higher rates endorsed by the interstate commerce commission. If this is true, then fuel efficiency would save more money as the price of diesel fuel rises (at $1.35 per gallon, he would save $2,025,000 in total if he buys the new trucks). Mr. Hoffman has come up with two possible forecasts as shown next- each of which he feels has had about a 50% chance of coming true. Under assumption 1, diesel fuel prices will stay relatively low; under the assumption, two diesel fuel prices will rise considerably. Sixty new trucks will cost Kennedy Trucking $5 million. Under a special provision, 25% in year 1, 38% in year 2, and 37% in year3. The firm has a tax rate of 40% and a cost of capital of 10% a) First, compute the yearly expected costs of diesel fuel for both assumption 1 (relatively low prices) and assumption 2 (high prices) from the following forecasts. Forecasts for assumption 1 (low fuel costs) Probability Price of Diesel per gallon Same ea yr Yr1 Yr2 Yr3 0.1 $0.80 $0.90 $1.00 0.2 1.00 1.10 1.10 0.3 1.10 1.20 1.30 0.2 1.30 1.45 1.45 0.2 1.40 1.55 1.60 Forecast for assumption 2 Probability Price of Diesel per gallon Same ea yr Yr1 Yr2 Yr3 0.1 $1.20 $1.50 $1.70 0.3 1.30 1.70 2.00 0.4 1.80 2.30 2.50 0.2 2.20 2.50 2.80 Show your work to answer d) Compute the net present value of the truck purchase for each fuel forecast assumption and the combined net present value (that is weigh the NPVs by 0.5)

Answer 1

a.