The Diamond Freight Company has been offered a seven-year contract to haul munit

Question

The Diamond Freight Company has been offered a seven-year contract to haul munitions for the government. Because this contract would represent new business, the company would have to purchase several new heavy-duty trucks at a cost of $350,000 if the contract were accepted. Other data relating to the contract follow:

Annual net cash receipts (before taxes) from the contract $105,000

Salvage value of the trucks at termination of the contract $18,000

The trucks will have a useful life of seven years. To raise money to assist in the purchase of the new trucks, the company will sell several old, fully depreciated trucks for a total selling price of $16,000. The company requires a 16% after-tax return on all equipment purchases. The tax rate is 30%. For tax purposes, the company computes depreciation deductions assuming zero salvage value and using straight-line depreciation on the full cost of the trucks ($350,000). The new trucks would be depreciated over the seven year life.

(a) Compute the net present value of this investment opportunity.

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Explanation / Answer

Hi, If you like my answer rate me first...that way only I can earn points. Thanks Annual net cash receipts (before taxes) from the contract = $105,000 Annual depreciation = $350000/7 = $50000 Annual net income (before taxes) from the contract = ($105,000 - $ 50000)* ( 1-30%) = $55000 *(1-30%) = $38500 Annual net cash receipts (after taxes) from the contract = $38500 + $50000 = $88,500 Initial = -$350000 + $16000 = -$334000 Year 1-7 = $88500 Year 7 = $18000 So NPV at I = 16% = $29,782 IRR = 18.924% Yes the firm should accept the contract

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