Question

Problem 10-16A Using present value techniques to evaluate alternative investment opportunities Swift Delivery is a small company that transports business packages between New York and Chicago. It operates a fleet of small vans that moves packages to and from a central depot within each city and uses a common carrier to deliver the packages between the depots in the two cities. Swift Delivery recently acquired approximately $4 million of cash capital from its owners, and its president, George Hay, is trying to identify the most profitable way to invest these funds. Todd Payne, the company's operations manager, believes that the money should be used to expand the fleet of city vans at a cost of $900,000. He argues that more vans would enable the company to expand its services into new markets, thereby increasing the revenue base. More specifically, he expects cash inflows to increase by $325,000 per year. The additional vans are expected to have an average useful life of four years and a combined salvage value of $100,000. Operating the vans will require additional working capital of $50,000, which will be recovered at the end of the fourth year. In contrast, Oscar Vance, the company's chief accountant, believes that the funds should be used to purchase large trucks to deliver the packages between the depots in the two cities. The conversion process would produce continuing improvement in operating savings and reduce cash outflows as follows. Year 1 Year 2 Year 3 Year 4 $175,000 $375,000 $450,000 $500,000 The large trucks are expected to cost $1,000,000 and to have a four-year useful life and a $81,250 salvage value. In addition to the purchase price of the trucks, up-front training costs are expected to amount to $20,000. Swift Delivery's management has established a 10 percent desired rate of return. Page 471 Required Round your computations to two decimal points a. Determine the net present value of the two investment alternatives. b. Calculate the present value index for each alternative. c. Indicate which investment alternative you would recommend. Explain your choice.

Answer 1

Solution a. SWIFT DELIVERY Net Present Value Cslculations Alternative 1: Cash Inflows Amount Table Value Present Value Annual Cash Inflows $ 3,25,000 3.170 $ 10,30,250 Salvage Value $ 1,00,000 0.683 $ 68,301 Working Capital recovery $ 50,000 0.683 $ 34,150 Total Cash Inflow $ 11,32,701 Cash Outflows: Cost of Vans $ 9,00,000 Working Capital Increase $ 50,000 Net Present Value $ 1,82,701 Alternative 2: Cash Inflows Year 1 Year 2 Year 3 Year 4 Salvage Value Total Cash Inflow Cash Outflows: Cost of Trucks Training Cost Net Present Value Amount $ 1,75,000 $ 3,75,000 $ 4,50,000 $ 5,00,000 $ 81,250 Table Value Present Value 0.909 $ 1,59,075 0.826 $ 3,09,750 0.751 $ 3,37,950 0.683 $ 3,41,500 0.683 $ 55,494 $ 12,03,769 $ $ $ 10,00,000 20,000 1,83,769 Solution b. PV index - Present Value of future cash flows / Initial Investment Present Value Indexes: Alternative 1 = ($1,132,701 / $950,000) = Alternative 2 ($1,203,769 / $1,020,000) = 1.19 1.18

Solution c. Net Present Value of Alternative 2 is higher than of Alternative 1, but Present Value Index of Alternaive 1 is higher than Alternative 2. Alternative 1 should be choosen as it represents a higher yield on the Initial Investments Note: Table used for above solution Year PV factor 0.909 0.826 0.751 0.683 PV of Annuity (4 yrs) 3.170 NM +

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