Question

Linkin Corporation is considering purchasing a new delivery truck. The truck has many advantages over the company’s current truck (not the least of which is that it runs). The new truck would cost $55,400. Because of the increased capacity, reduced maintenance costs, and increased fuel economy, the new truck is expected to generate cost savings of $8,500. At the end of 8 years the company will sell the truck for an estimated $27,000. Traditionally the company has used a rule of thumb that a proposal should not be accepted unless it has a payback period that is less than 50% of the asset’s estimated useful life. Larry Newton, a new manager, has suggested that the company should not rely solely on the payback approach, but should also employ the net present value method when evaluating new projects. The company’s cost of capital is 8%.

Click here to view PV table.

(a)

Compute the cash payback period and net present value of the proposed investment.

Answer 1

cash payback period calculates the time period within which the initial investment is covered back in the form of cash inflow.

years	cash flow	cummulative cash flow
1	$8,500	$8,500
2	$8,500	$17,000[8500+8500]
3	$8,500	$25,500
4	$8,500	$34,000
5	$8,500	$42,500
6	$8,500	$51,000
7	$8,500	$59,500
8	$35,500[8500+27000sell value]	$95000

payback period = initial investment / cash flow per year

=$55,400/8,500

=6.52 years

proposal should not be accepted unless it has a payback period that is less than 50% of the asset’s estimated useful life.

as per this rule payback period should be less than 4years (50%*8years] however the actual is 6.52years so as per this rule project should not be accepted.

pay back period is not the best capital budgeting technique as it ignores time value of money. Net present value uses time value factor.

Net present value is difference between initial investment and present value of cash inflow.project should be accepted if NPV is positive.

years	cash flow	PV factor of $1 at 8%	present value of cash flow
0	($55,400)	1	($55,400)
1-8	$8,500	5.7466	$48,846[8500*5.7466]
8	$27,000	0.5403	$14,588[27000*0.5403]
		Net present value	$8,034	[48846+14588-55400]

Net present value iS positive hence project should be accepted.