Jeremy Pruitt Ltd is considering the replacement of a delivery truck. The current truck could last for 3 more years. Operating costs are 5000 per year. We are currently depreciating it at 4000 per year. We could sell it at the end of the 3 years for 2000 with a book value of zero. If we purchase the new truck for 32000, we could use three year MACRS. We could sell the old truck now for 7000. Operating costs would drop to 1000 per year. We can sell the new truck for 15000 at the end of the 3rd year. Tax rate is 40%, WACC is 10%. Should we replace the truck?

NPV =  - 4433  

As the NPV of the replacement project is negative,

the truck should not be replaced.

Explanation:

                                                                           0               1             2           3

Savings in operating costs (5000-1000):                       4000    4000     4000

Incremental depreciation:-      

Depreciation on the new truck                                      10666    14224    4739

Depreciation on the old truck                                         4000     4000    4000

Incremental depreciation                                                6666     10224    739  

Incremental NOI                                                             -2666      -6224    3261

Tax at 40%                                                                      -1066       -2490    1304

Incremental NOPAT                                                       -1599        -3734   1956

Add: Incremental depreciation                                       6666       10224   739

Incremental OCF                                                             5066       6490   2696

Capital expenditure:-    

Cost of new truck                                        32000    

Less: After tax salvage value of old

NOTE THAT, the book value = 4000*3 =

$12,000 (depreciation per annum is 4000

and three years life is left for the old machine)

truck = 7000 + (12000-7000) × 40% =       9000    

Net initial investment                                  23000    

Incremental terminal salvage value:-    

After tax salvage value of new

truck = 15000 - (15000-2371)× 40% =                                                         9948

Less: After tax salvage value lost on old

truck = 2000 × (1 - 40%) =                                                                            1200

Incremental net residual value                                                                   8748

After tax annual cash flows                       -23000       5066       6490     11444

PVIF at 10%                                                  1           0.90909  0.82645  0.75131

PV at 10%                                                    -23000       4606       5363     8598  

NPV                                                             -4433    

CONCLUSION:      

As the NPV of the replacement project is negative,

the truck should not be replaced.