Ayayai Corporation is considering purchasing a new delivery

Ayayai 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 $64,380. Because of the increased capacity, reduced maintenance costs, and increased fuel economy, the new truck is expected to generate cost savings of $8,700. At the end of 8 years, the company will sell the truck for an estimated $27,700. 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%.

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(a)

Compute the cash payback period and net present value of the proposed investment. (If the net present value is negative, use either a negative sign preceding the number e.g. -45 or parentheses e.g. (45). Round answer for present value to 0 decimal places, e.g. 125. Round answer for Payback period to 1 decimal place, e.g. 10.5. For calculation purposes, use 5 decimal places as displayed in the factor table provided.)

(b)

Does the project meet the company’s cash payback criteria?

Does it meet the net present value criteria for acceptance?

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Solution

Part A

The cash payback period is:
Investment ÷ annual cost savings = $64380 ÷ $8700 = 7.40 years.

The net present value is:

Cash Flows × 8% Discount Factor = Present Value

Present value of net annual cash flows =cost saving *pvifa(8%,8yrs)= $8700 × 5.74664 = $49996

Present value of salvage value=salvage value *pvif(8%,8yrs)= 27,700 × 0.54027 = 14965

= 64961 (49996+14965)

Capital investment = 64380

Net present value $581 (64961-64380=581)

Part B

Does the project meet the company’s cash payback criteria? NO

In order to meet the cash payback criteria, the project would have to have a cash payback period of less than 4 years (8 ÷ 2). It does not meet this criteria.

Does it meet the net present value criteria for acceptance?

YES

The net present value is positive, however, suggesting the project should be accepted. The reason for the difference is that the project\'s high estimated salvage value increases the present value of the project. The net present value is a better indicator of the project\'s worth.