Question

Jeremy Pruitt Ltd is considering the replacement of a delivery truck. The current truck could last for 3 more years. Operating costs are 5000 per year. We are currently depreciating it at 4000 per year. We could sell it at the end of the 3 years for 2000 with a book value of zero. If we purchase the new truck for 32000, we could use three year MACRS. We could sell the old truck now for 7000. Operating costs would drop to 1000 per year. We can sell the new truck for 15000 at the end of the 3rd year. Tax rate is 40%, WACC is 10%. Should we replace the truck?

Answer 1

Answer: NPV = - 4433

As the NPV of the replacement project is negative,

the truck should not be replaced.

Step-by-step explanation:

0 1 2 3

Savings in operating costs (5000-1000): 4000 4000 4000

Incremental depreciation:-

Depreciation on the new truck 10666 14224 4739

Depreciation on the old truck 4000 4000 4000

Incremental depreciation 6666 10224 739

Incremental NOI -2666 -6224 3261

Tax at 40% -1066 -2490 1304

Incremental NOPAT -1599 -3734 1956

Add: Incremental depreciation 6666 10224 739

Incremental OCF 5066 6490 2696

Capital expenditure:-

Cost of new truck 32000

Less: After tax salvage value of old

NOTE THAT, the book value = 4000*3 =

$12,000 (depreciation per annum is 4000

and three years life is left for the old machine)

truck = 7000 + (12000-7000) × 40% = 9000

Net initial investment 23000

Incremental terminal salvage value:-

After tax salvage value of new

truck = 15000 - (15000-2371)× 40% = 9948

Less: After tax salvage value lost on old

truck = 2000 × (1 - 40%) = 1200

Incremental net residual value 8748

After tax annual cash flows -23000 5066 6490 11444

PVIF at 10% 1 0.90909 0.82645 0.75131

PV at 10% -23000 4606 5363 8598

NPV -4433

CONCLUSION:

As the NPV of the replacement project is negative,

the truck should not be replaced.