Question

Problem 10-22 Economic Life The Scampini Supplies Company recently purchased a new delivery truck. The new truck cost $22,500, and it is expected to generate net after-tax operating cash flows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The expected salvage values after tax adjustments for the truck are given below. The company's cost of capital is 11.5 percent. Year Annual Operating Cash Flow Salvage Value 0 -$22,500 $22,500 1 6,250 17,500 2 6,250 14,000 3 6,250 11,000 4 6,250 5,000 5 6,250 0 What is the optimal number of years to operate the truck? Would the introduction of salvage values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project? -Select-IIIIII I. Salvage possibilities would have no effect on NPV and IRR. II. No. Salvage possibilities could only raise NPV and IRR. III. Yes. Salvage possibilities could only lower NPV and IRR.

Answer 1

Cost of Truck is $22500

After tax operational cash flow including depreciation is $6250

As mentioned that cost of capital is 11.5% which comes out to be ($22500*11.5%) $2587.5

So to get the optimum life of the truck maximum depreciation can be ($6250 - $2587.5) $3662.5

Hence Optimum life of the truck is Cost of truck/ depreciation, this comes out to be $22500/$3662.5 = 6.14 years

Future depreciation does not account for cash flow. Hence cannot affect NPV or IRR.

So for second part of the question, answer is " I. Salvage possibilities would have no effect on NPV and IRR."