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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

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. 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 discuss: Whether the S Company has to operate the truck until the end of its five year.

Explanation

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$6,2500

The formula to compute the NPV for an abandonment option is as follows:

NPV=[Initial cost of investment+(Annual After-tax cash flow+Abandonment value)(1+WACC)1]

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.

Summary Introduction

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

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