The Diamond Freight Company has been offered a seven-year contract to haul munit
ID: 2415060 • Letter: T
Question
The Diamond Freight Company has been offered a seven-year contract to haul munitions for the government. Because this contract would represent new business, the company would have to purchase several new heavy-duty trucks at a cost of $350,000 if the contract were accepted. Other data relating to the contract follow:
Annual net cash receipts (before taxes)
from the contract
Salvage value of the trucks at termination
of the contract
The trucks will have a useful life of seven years. To raise money to assist in the purchase of the new trucks, the company will sell several old, fully depreciated trucks for a total selling price of $16,000. The company requires a 16% after-tax return on all equipment purchases. The tax rate is 30%. For tax purposes, the company computes depreciation deductions assuming zero salvage value and using straight-line depreciation on the full cost of the trucks ($350,000). The new trucks would be depreciated over the seven year life.
The Diamond Freight Company has been offered a seven-year contract to haul munitions for the government. Because this contract would represent new business, the company would have to purchase several new heavy-duty trucks at a cost of $350,000 if the contract were accepted. Other data relating to the contract follow:
Annual net cash receipts (before taxes)
from the contract
Salvage value of the trucks at termination
of the contract
The trucks will have a useful life of seven years. To raise money to assist in the purchase of the new trucks, the company will sell several old, fully depreciated trucks for a total selling price of $16,000. The company requires a 16% after-tax return on all equipment purchases. The tax rate is 30%. For tax purposes, the company computes depreciation deductions assuming zero salvage value and using straight-line depreciation on the full cost of the trucks ($350,000). The new trucks would be depreciated over the seven year life.
Required: (a) Compute the net present value of this investment opportunity. (Round to the nearest dollar amount. Omit the "$" sign in your response.)(b) Compute the internal rate of return of this investment opportunity. (Round to two decimal places. Omit the "%" sign in your response.)
Explanation / Answer
Details of truck purchased are as given below:
Old Trucks sold at $16,000
Truck Cost $350,000
Annual net cash receipts $105,000
Life of truck 7 years
Discount rate used is 16%
Tax rate is30%
a.
NPV is calculated as under:
Net Present Value = NPV is the difference between present value of cash inflow and
Cash Outflows.
NPV= PV of Cash inflow- PV of Cash Outflow
Where C0 = Initial Investment
C1= Net cash inflow at the end of year
r = Rate of Return (Discount Rate)
T= Time
Now here Initial Investment is $350,000 so C0 is $350,000
Net Annual Cash flows is $105,000 (Assuming Cash inflow- Cash Outflow) so C1 to C7
is $105,000-30% tax= $73,500
Time= 5 years
Discount rate (as given in question) = 16%
So NPV is calculated as under:
Year
0
1
2
3
4
5
6
7
Cash outflow
-350,000
Cash Inflow
16,000
73,500
73,500
73,500
73,500
73,500
73,500
91,500
Discount rate
16%
Time
7 years
PV factor
0.862
0.743
0.641
0.552
0.476
0.41
0.354
PV of cash outflow
-350,000
PV of cash inflow
16,000
63357
54610.5
47113.5
40572
34986
30135
32391
Present Value
-334,000
63357
54610.5
47113.5
40572
34986
30135
32391
NPV
-30,835
Internal rate of return= ra+ NPVa/(NPVa –NPVb ) (rb-ra)
Where ra= Lower discount rate
rb= higher discount rate
Na= NPV at ra
Nb= NPV at rb
Time
Cash Flow
16%
NPVa
10%
NPV b
0
-334,000
1
-334,000
1
-334000
1
73,500
0.862
63,357
0.909
66811.5
2
73,500
0.743
54,611
0.826
60711
3
73,500
0.641
47,114
0.751
55198.5
4
73,500
0.552
40,572
0.683
50200.5
5
73,500
0.476
34,986
0.621
45643.5
6
73,500
0.41
30,135
0.564
41454
7
91,500
0.354
32,391
0.513
46939.5
198,500
-30,835
32,959
So IRR= 10%+ 32,959/(32,959-(-30,835) *(16%-10%)
Year
0
1
2
3
4
5
6
7
Cash outflow
-350,000
Cash Inflow
16,000
73,500
73,500
73,500
73,500
73,500
73,500
91,500
Discount rate
16%
Time
7 years
PV factor
0.862
0.743
0.641
0.552
0.476
0.41
0.354
PV of cash outflow
-350,000
PV of cash inflow
16,000
63357
54610.5
47113.5
40572
34986
30135
32391
Present Value
-334,000
63357
54610.5
47113.5
40572
34986
30135
32391
NPV
-30,835
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