Madrano\'s Wholesale Fruit Company located in McAllen, Texas is considering the

Question

Madrano's Wholesale Fruit Company located in McAllen, Texas is considering the purchase of a new fleet of tractors to be used in the delivery of fruits and vegetables grown in the Rio Grande Valley of Texas. If it goes through with the purchase, it will spend $400,000 on eight rigs. The new trucks will be kept for 5 years, during which time they will be depreciated toward a $40,000 salvage value using straight-line depreciation. The rigs are expected to have a market value in 5 years equal to their salvage value. The new tractors will be used to replace the company's older fleet of eight trucks which are fully depreciated but can be sold for an estimated $20,000 (because the tractors have a current book value of zero, the selling price is fully taxable at the firm's 30 percent tax rate). The existing tractor fleet is expected to be useable for 5 more years after which time they will have no salvage value. The existing fleet of tractors uses $200,000 per year in diesel fuel, whereas the new, more efficient fleet will use only $150,000. In addition, the new fleet will be covered under warranty, so the maintenance costs per year are expected to be only $12,000 compared to $35,000 for the existing fleet. What are the differential operating cash flow savings per year during years 1 through 5 for the new fleet? What is the initial cash outlay required to replace the existing fleet with the newer tractors? What does the timeline for the replacement project cash flows for years 0 through 5 look like? If Madrano requires a discount rate of 15 percent for new investments, should the fleet be replaced?

Explanation / Answer

a Operating Cash Flow Differential are as follows

Differential Operating Cash Flow for Year 1 to 5 is $94600.

b Initial Outlay requried is as follows

Cost of New Fleet ( $400000)

After Tax Cost of Sale Proceeds of Old

Fleet $14000

Initial Outlay required=$386000

c Timeline =Initial Outlay/Annual Differential Cashflow

=$386000/$94600

=4.08 Years

d

Initial Outlay ($386000)

Pv of Operating Cash Flow = $94600*3.3522

=$317118

Salvage Value= 40000*0.4972

=$19888

NPV=($386000)+$317118+$19888

=($386000)+$337006

=($48994)

As the NPV of the project is negative @15%discount rate is negative fleet should not be replaced.

Exisiting Fleet New Fleet Differential cash Flo Diesel cost $20000 $150000 $50000 Maintenance Cost $35000 $12000 $23000 Tax Saving on Depreication 0 $21600 $21600 Differential Operating Cash Flow $94600

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