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? Would the introduction of abandonment values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project? Explain.

FINANCIAL ACCOUNTING
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ISBN:9781259964947
Author:Libby
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Chapter1: Financial Statements And Business Decisions
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ABANDONMENT OPTION The Scampini 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 $6,250 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 10%. 

                        Year                Annual After-Tax Cash Flow             Abandonment Value

                        0                      ($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         

  1. 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. Would the introduction of abandonment values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project? Explain.
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