Question

CHECK FIGURES a. NPV of the vans investment: $182,658.08 b. The profitability index for the trucks investment: 1.18 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.

NPV of alternative 1-Expansion of fleet of city vans

	Year	Cash flow (a)	PV factor @ 10%	Present Value (a*b)
Cash inflow	1-4	325,000	3.17	1,030,250
Salvage value	4	100,000	0.683	68,300
Additional working capital recovered	4	50,000	0.683	34,150
Present Value of cash inflows				1,132,700
Less: Cash outflows
Cost of Vans	0	900,000	1	(900,000)
Additional working capital	0	50,000	1	(50,000)
Net Present Value				182,700

NPV of alternative 2: Trucks Investment

	Year	Cash flow (a)	PV factor @ 10% (b)	Present Value (a*b)
Savings in cost/ cash outflow reduction	1	175,000	0.909	159,075
	2	375,000	0.826	309,750
	3	450,000	0.751	337,950
	4	500,000	0.683	341,500
Present value of savings /cash outflows reduction				1,148,275
Add: PV of Salvage value	4	81,250	0.683	55,494
			(c)	1,203,769
Less:
Cost of Trucks	0	1,000,000	1	1,000,000
Training cost	0	20,000	1	20,000
			(d)	1,020,000
Net Present Value			(c)-(d)	183,769

Solution b:

Present Value Index=NPV/Initial outlay

Alternative 1: PVI = 182700/950,000

=0.19

Alternative 2: PVI =183769/1020000

=0.18

Profitability index = (NPV + Initial outlay)/Iniitial outlay

Alternative 1: PI = 1132700/950000 = 1.19

Alternative 2: PI = 1203769/1020000 = 1.18

Solution C:

NPV basis: As the NPV of alternative 2 is slightly higher than alternative 1, investment in alternative 2 shall be recommended.

PVI/PI basis: Alternative 1 has higher value than alternative 2 so investment in alternative1 shall be recommended.

Since the alternatives are mutually exclusive and unequal investment , NPV method is preferrable. Hence investment in trucks (alternative 2) is recommended.