Linkin Corporation is considering purchasing a new delivery truck. The truck has

Question

Linkin 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 $55,100. Because of the increased capacity, reduced maintenance costs, and increased fuel economy, the new truck is expected to generate cost savings of $8,600. At the end of 8 years the company will sell the truck for an estimated $28,300. 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%.

? years

? years

Explanation / Answer

Assets useful life is 8 Years. So, Payback deadline is 4 years (50% of 8 Years).It means if payback period is not less than 4 years project will be rejected on Payback Basis. Years Cash flow Cumulative cash flow Cash Payback Period 0 $    -55,100 $                             -55,100 = 6+(3500/8600) 1 $        8,600 $                             -46,500 =           6.41 Years 2 $        8,600 $                             -37,900 3 $        8,600 $                             -29,300 4 $        8,600 $                             -20,700 5 $        8,600 $                             -12,100 6 $        8,600 $                               -3,500 7 $        8,600 $                                 5,100 8 $      36,900 $                               42,000 Cash flow at end of year 8 = Cost saving+Selling price of machine = $    8,600 + $ 28,300 = $ 36,900 Payback period is time upto which initial cash investment is recovered back.It can be seen from above table that in 7th year cumulative cash flow becomes positive. It shows that initial investment is recoverd in 7th year that is not less than 4 year. So on the basis of Payback Project has been rejected. Now let us check Net Present Value. Years Cash flow Discount factor Present Value 0 $    -55,100                                     1.000 $ -55,100 1 $        8,600                                     0.926 $     7,963 2 $        8,600                                     0.857 $     7,373 3 $        8,600                                     0.794 $     6,827 4 $        8,600                                     0.735 $     6,321 5 $        8,600                                     0.681 $     5,853 6 $        8,600                                     0.630 $     5,419 7 $        8,600                                     0.583 $     5,018 8 $      36,900                                     0.540 $   19,936 Net Present Value $     9,611 Since Project has positive Net Present Value it is accepted. So, Cash Payback Period 6.41 Years Net Present Value $ 9,611 The Object of Capital budgeting is wealth maximization.So, in case of difference Net Present Value basis should be adopted. So, on the basis of Net Present Value Project should be accepted even payabck is beyond the deadline.

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