Problem-7 (Net present value analysis – total and incremental cost approach)

The National Transport Company has a number of large trucks. One of the trucks is in poor condition and needs an immediate renovation at a cost of $100,000. An overhaul of engine will also be needed 6-years from now at a cost of $10,000. If theses costs are incurred, the truck will be useful for 12 years. After 12-year period, it will be sold at a salvage value (scrap value) of $30,000. At this time, the salvage value of the truck is $35,000. The total annual revenues of the truck will be $200,000 and the total cost to operate the truck will be $150,000 per year.

Alternatively, National Transport Company can purchase a new truck for $180,000. The new truck will require some repairs at the end of 6-year period at a cost of $5,000. Its salvage value will be $30,000 after its useful life of 12 years. The total annual revenues of the new truck will be $200,000 and its operating cost will be $110,000 per year.

The company’s required rate of return is 15% before taxes.

Required: Should National Transport Company renovate the old truck or purchase a new truck. Use the following approaches to net present value (NPV) analysis for your answer:

1. Total cost approach.
2. Incremental cost approach.

(Ignore income tax in your computations.)

 Solution:

(1) Total cost approach to NPV:

* Value from “present value of an annuity of $1 in arrears table“.
**Value from “present value of $1 table”.

Net present value in favor of buying the new truck:

NPV with new truck – NPV with old truck

= $346,340 – $172,340

= $174,000

Since the NPV of new truck surpasses the NPV of old truck by $174,000, the company should buy the new truck rather than renovating the old one.

(2) Incremental cost approach to NPV:

* Value from “present value of an annuity of $1 in arrears table“.
**Value from “present value of $1 table“.

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