Palo Alto Corporation is considering purchasing a new delivery truck. The truck

Question

Palo Alto Corporation is considering purchasing a new delivery truck. The truck has many advantages over the company’s current truck (not the least of which is that it runs). The new truck would cost $57,220. Because of the increased capacity, reduced maintenance costs, and increased fuel economy, the new truck is expected to generate cost savings of $8,490. At the end of 8 years the company will sell the truck for an estimated $28,240. Traditionally the company has used a rule of thumb that a proposal should not be accepted unless it has a payback period that is less than 50% of the asset’s estimated useful life. Larry Newton, a new manager, has suggested that the company should not rely solely on the payback approach, but should also employ the net present value method when evaluating new projects. The company’s cost of capital is 8%.

TABLE 1 Future Value of 1 Periods 4% 5% 6% 170 790 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.04000 1.05000 1.06000 1.07000 1.08000 1.09000 1.10000 1.11000 .12000 1.15000 1.08160 1.10250 .12360 1.14490 1.16640 1.18810 1.21000 1.23210 1.25440 .32250 1.12486 .15763 1.19102 1.22504 1.25971 1.29503 .33100 1.36763 1.40493 1.52088 1.16986 1.21551 1.26248 1.31080 1.36049 1.41158 1.46410 1.51807 1.57352 1.74901 1.21665 1.27628 1.33823 1.40255 1.46933 1.53862 1.61051 1.68506 1.76234 2.01136 1.26532 1.34010 1.41852 1.50073 1.58687 1.67710 1.77156 1.87041 1.97382 2.31306 1.31593 1.40710 1.50363 1.60578 1.71382 1.82804 1.94872 2.07616 2.21068 2.66002 1.368571.47746 1.59385 1.71819 1.85093 1.99256 2.14359 2.30454 2.47596 3.05902 1.42331 .55133 1.68948 1.83846 1.99900 2.17189 2.35795 2.55803 2.77308 3.51788 1.48024 1.62889 1.79085 1.96715 2.15892 2.36736 2.59374 2.83942 3.10585 4.04556 1.539451.71034 1.89830 2.10485 2.33164 2.58043 2.85312 3.15176 3.47855 4.65239 1.60103 1.79586 2.01220 2.25219 2.51817 2.81267 3.13843 3.49845 3.89598 5.35025 1.665071.88565 2.13293 2.40985 2.71962 3.0658 3.45227 3.88328 4.36349 6.15279 1.73168 1.97993 2.26090 2.57853 2.93719 3.34173 3.79750 4.31044 4.88711 7.07571 1.800942.07893 2.39656 2.75903 3.17217 3.64248 4.17725 4.78459 5.47357 8.13706 1.87298 2.18287 2.54035 2.95216 3.42594 3.97031 4.59497 5.31089 6.13039 9.35762 1.94790 2.29202 2.69277 3.15882 3.70002 4.32763 5.05447 5.89509 6.86604 10.76126 18 2.02582 2.40662 2.85434 3.37993 3.99602 4.71712 5.55992 6.54355 7.68997 12.37545 19 2.10685 2.52695 3.02560 3.61653 4.31570 5.14166 6.11591 7.26334 8.61276 14.23177 2.19112 2.65330 3.20714 3.86968 4.66096 5.60441 6.72750 8.06231 9.64629 16.36654 2 10 12 13 14 15 16 17 20

Explanation / Answer

Cash payback period should be computed by dividing the cost of the truck by the annual cost savings.

Cash payback period = Cost of truck / Annual cost savings = $57,220 / $8,490 = 6.74 years

Compute the net present value of the truck using the following formula:

Net present value

= Present value of annual cost savings + Present value of salvage value - cost of truck

Where,

Present value of annual cost savings

= Annual cost savings x Present value of an annuity of $1 per period for 8 periods at 8%

= $8,490 x 5.74664

= $48,788.97

Present value of salvage value

= Salvage value x Present value of $1 per period for 8 periods at 8%

= $28,240 x 0.54027

= $15,257.22

And,

Initial investment = $57,220

Therefore,

Net present value of the truck = $$48,788.97 + $15,257.22 - $57,220 = $6,826.19

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