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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937

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Fundamentals of Financial Manageme...

9th Edition
Eugene F. Brigham + 1 other
ISBN: 9781305635937
Textbook Problem
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ABANDONMENT OPTION The Sorensen Supplies Company recently purchased a new delivery truck. The new truck costs $22,500; and it is expected to generate after-tax cash flows, including depreciation, of $5,875 per year. The truck has a 5-year expected life. The expected year-end abandonment values (salvage values after tax adjustments) for the truck are given here. The company's WACC is 9%.

Year Annual After-Tax Cash Flow Abandonment Value
1 ($22,500
2 5,875 $17,000
3 5,875 15,000
4 5,875 9,000
5 5,875 4,750
6 5,875 0
  1. a. Should the firm operate the truck until the end of its 5-year physical life; if not, what is the truck's optimal economic life?
  2. b. Would the introduction of abandonment values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project? Explain.

a.

Summary Introduction

To explain: The option for firm to operate the truck till the end of 5th year and or not and the optimum economic life of a truck.

Introduction:

Abandonment Options:

This is presuming in capital budgeting that a project is operated for the full estimated life. Sometime the company has the option to replace the old machine with the new, as it has the option to discard the project in between its operating life. By this option, life of project increases and the risk related to old machine is reduced.

Net Present Value (NPV):

NPV is the technique of capital budgeting. Selection or rejection of the project is depending on the NPV of the project. If the project has positive NPV, than accept the project. If the NPV is negative, than reject the project.

Internal Rate of Return (IRR):

IRR is a capital budgeting method that involves the time value of money concept. The IRR percentage gives the idea about the profitability arises from an investment. The IRR of a project is calculated with the help of NPV calculations.

Explanation

Yes, the firm should operate a truck till the end of the 5th year, as in 5th year the abandon value is zero but NPV is positive. Also the IRR has been highest for three years.

Working Notes:

Calculate NPV and IRR of truck where life is 1 Year.

NPV=(Annual operating cash flows+Salvage values)(1+Rate)1Initial investment=($5,875+$17,000)(1+9%)1$22,500=$22,8751.09$22,500=$1513.76

Calculate IRR,

Table (1)

Calculate NPV and IRR of truck where life is 2 Year.

NPV=[Annual cash flows(1+Rate)1+(Annual operating cash flows+Salvage values)(1+Rate)2Initial investment]=[$5,875(1+9%)1+($5,875+$15,000)(1+9%)2$22,500]=$5,389.91+$17,570.07$22,500=459.98

Calculate IRR,

Table (2)

Calculate NPV and IRR of truck where life is 3 Year.

NPV=[Annual cash flows(1+Rate)1+(Annual operating cash flows+Salvage values)(1+Rate)2Initial investment]=[$5,875(1+9%)1+$5,875(1+9%)2+($5,875+$9,000)(1+9%)3$22,500]=$5,389.91+$4,944.87+11,486.23$22,500=$678.99

Calculate IRR,

b.

Summary Introduction

To explain: Whether the introduction of abandonment values reduces the expected NPV and or IRR of a project.

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