Fundamentals of Financial Manageme...
Fundamentals of Financial Manageme...
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 |
- 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?
- 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.
To discuss: Whether the S Company has to operate the truck until the end of its five year.
Given information:
S Company has purchased a new delivery truck for $22,500 and expected after-tax cash flows are $6,250 per year (inclusive depreciation). The expected life of the truck is 5 years and WACC is 10 percent. The expected year-end abandonment values of the truck are as follows:
| Year |
Annual After-tax cash flow |
Abandonment value |
| 0 | ($22,500) | 0 |
| 1 | $6,250 | $17,500 |
| 2 | $6,250 | $14,000 |
| 3 | $6,250 | $11,000 |
| 4 | $6,250 | $5,000 |
| 5 | $6,250 | 0 |
The formula to compute the NPV for an abandonment option is as follows:
Where,
NPV refers to the net present value
WACC refers to the weighted average cost of capital
n refers to the number of period
Compute the NPV of abandonment for Year 1:
Note: In this case, there are five scenarios as to when abandon the truck. The company can sell the truck after one year of service is Scenario 1. Now, determine the NPV of this scenario.
The table below shows the Excel formula to calculate the NPV of abandonment for Year 1:
The table below shows the calculated values of the NPV of abandonment for Year 1:
Hence, the NPV of this scenario is −$909
b.
To discuss: Whether the introduction of abandonment values reduces the NPV expected or IRR of a project.
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