Question

PA8.

LO 11.4Pompeii’s Pizza has a delivery car that it uses for pizza deliveries. The transmission needs to be replaced and there are several other repairs that need to be done. The car is nearing the end of its life, so the options are to either overhaul the car or replace it with a new car. Pompeii’s has put together the following budgetary items:

Purchase cost new Transmission and other repairs Annual cash operating cost Fair market value now Fair market value in five years Present Car New Car $31,000 $ 8,500 12,500 10,000 5,000 500 5,000

If Pompeii’s replaces the transmission of the pizza delivery vehicle, they expect to be able to use the vehicle for another 5 years. If they sell the old vehicle and purchase a new vehicle, they will use that vehicle for 5 years and then trade it in for another new pizza delivery vehicle. If they trade for the new delivery vehicle, their operating expenses will decrease because the new vehicle is more gas efficient and the maintenance on a new car is less. This project is analyzed using a discount rate of 12%. What should Pompeii’s do?

Answer 1

• If the car is replaced with a new car

Cash outflows due to purchase - $ 31000

Present Value of Operating costs (for 5 years) - 10000 * 3.605 = $ 36050

Total outflows - $ 67050

Sale of old vehicle - $ 5000

Present Value of Scrap of new car - $ 5000 * 0.567 = $ 2835

Total Inflows - $ 7835

Net outflows - 67050 - 7835 = $ 59215

• If the existing car is overhauled

Repairs - $ 8500

Operating costs - 12500 * 3.605 = $ 45063

Total Outflows - $ 53563

PV of Scrap - 500 * 0.567 = 283

Net outflows - $ 53280

Since the net outflow for purchase of a new car is more than that of repairing the existing one (by $5935) , it is wiser not to purchase a new car and instead continue with the present car by overhauling it.

NOTE - Present value is calculated by discounting at 12% for 5 years and for scrap, the discounting factor of 5th year is used. = (1/(1.12)⁵)