Question

Driving Student, owned by UCW alumni, is considering purchasing a new, bigger, car (bus) to replace an existing car that has a book value of zero, but a market value of $15,000 The bus costs $90,000 and is expected to provide savings and increased profits of $20,000 per year for the next ten years. The new bus has an expected useful life of ten years, after which the estimated salvage value would be $10,000. Assuming straight-line depreciation, a 34% effective tax rate, and a cost of capital (i.e. discount rate) of 12%, should Driving Student replace the existing car?

Answer 1

Driving Student should calculate the Net Present Value of replacing their existing vehicle with a new bus, considering the cost, expected savings, depreciation, tax rate, and discount rate. The NPV calculation will help determine whether the new bus investment is financially viable.

Step-by-step explanation:

The question asks whether the company Driving Student should replace an existing car with a new bus, considering various financial factors. To determine this, we need to calculate the Net Present Value (NPV) of the investment to see if it would be profitable for the company. The bus costs $90,000 and is expected to generate savings and increased profits of $20,000 per year for the next ten years, with a salvage value of $10,000 at the end of its useful life. Using straight-line depreciation, the annual depreciation expense would be ($90,000 - $10,000) / 10 = $8,000 per year. The cost of capital, or discount rate, is 12%. We need to consider tax savings due to depreciation, which are tax rate × depreciation expense. Therefore, the annual tax savings would be 34% × $8,000 = $2,720.

The annual net cash flow from the bus, before tax and depreciation, would be $20,000. After considering tax and adding back the tax savings from depreciation, the net cash flow would be: $20,000 - ($20,000 × 34%) + $2,720 = $15,720. Now, we discount this annual cash flow using the discount rate of 12% over ten years and add the present value of the salvage value, also discounted at 12%. If the NPV is positive, it would be favorable for Driving Student to proceed with the purchase of the new bus.

Answer 2

To decide whether Driving Student should replace its existing car with a new bus, we must calculate the net present value of the investment, taking into account the purchase price, annual savings, tax savings from depreciation, and salvage value, all discounted at the company's cost of capital.

Step-by-step explanation:

The student's question involves evaluating whether Driving Student, owned by UCW alumni, should replace an existing car with a new bus based on financial projections. To assess this decision, we must consider the cost of the new bus, expected savings and increased profits, salvage value at the end of its useful life, tax implications of depreciation, and the effect of discounting future cash flows at the company's cost of capital.

The new bus has a purchase price of $90,000, and it will provide annual savings and additional profits of $20,000. Over a ten-year period, these savings sum up to $200,000. Straight-line depreciation means the bus will depreciate at a rate of $8,000 per year (calculated by taking the purchase price of $90,000 minus the salvage value of $10,000, divided by the 10-year useful life), which has tax implications. The effective tax rate of 34% will reduce the tax burden by $2,720 per year (34% of the annual depreciation). When considering the discount rate of 12%, the net present value (NPV) of all future cash flows must be positive for the investment to be worthwhile. To provide an accurate recommendation, a complete NPV calculation that takes into account all these factors is necessary. Without doing the actual calculation, we cannot make a recommendation on whether to replace the existing car with the new bus.