Jane’s Auto Care is considering the purchase of a new tow truck. The garage doesn’t currently have a tow truck, and the $60,000 price tag for a new truck would represent a major expenditure. Jane Austen, owner of the garage, has compiled the estimates shown below in trying to determine whether the tow truck should be purchased.
| Initial cost | $60,000 | ||
| Estimated useful life | 8 years | ||
| Net annual cash flows from towing | $8,000 | ||
| Overhaul costs (end of year 4) | $6,000 | ||
| Salvage value | $12,000 |
Jane’s good friend, Rick Ryan, stopped by. He is trying to convince Jane that the tow truck will have other benefits that Jane hasn’t even considered. First, he says, cars that need towing need to be fixed. Thus, when Jane tows them to her facility, her repair revenues will increase. Second, he notes that the tow truck could have a plow mounted on it, thus saving Jane the cost of plowing her parking lot. (Rick will give her a used plow blade for free if Jane will plow Rick’s driveway.) Third, he notes that the truck will generate goodwill; people who are rescued by Jane’s tow truck will feel grateful and might be more inclined to use her service station in the future or buy gas there. Fourth, the tow truck will have “Jane’s Auto Care” on its doors, hood, and back tailgate—a form of free advertising wherever the tow truck goes. Rick estimates that, at a minimum, these benefits would be worth the following.
| Additional annual net cash flows from repair work | $3,000 | ||
| Annual savings from plowing | 750 | ||
| Additional annual net cash flows from customer “goodwill” | 1,000 | ||
| Additional annual net cash flows resulting from free advertising | 750 |
The company’s cost of capital is 9%.
What is the present net value?
A)
alculate the net present value, ignoring the additional benefits described by Rick. Should the tow truck be purchased
| Cash Flows | Dicount factor at 9% |
Prasent Value | |
| Present value of net annual cash flow | 8000 | 5.53482 | 44278.6 |
| Present value of cost of overhaul | -6000 | 0.70843 | -4250.6 |
| Present value of salvage value | 12000 | 0.50187 | 6022.44 |
| Total | 46050.4 | ||
| Capital investment | 60000 | ||
| Net present value | -13950 |
B)
Calculate the net present value, incorporating the additional benefits suggested by Rick. Should the tow truck be purchased?
Answer:
| Cash Flows | Dicount factor at 9% |
Prasent Value | |
| Present value of net annual cash flow | 13500 | 5.53482 | 74720.1 |
| Present value of cost of overhaul | -6000 | 0.70843 | -4250.6 |
| Present value of salvage value | 12000 | 0.50187 | 6022.44 |
| Total | 76491.9 | ||
| Capital investment | 60000 | ||
| Net present value | 16491.9 |
PV Cash Flows = $8,000 + ($3,000 + $750 + $1,000 + $750) = $13,500)
Based on the revised figures, the tow truck has a positive net present value and therefore should be purchased
