The Diamond Freight Company has been offered a seven-year contract to haul munit
ID: 2589523 • 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:
Explanation / Answer
Answer:
Initial investment is
= cost of New truck -cash received from the sale of the old trucks
=$350000-($16000*(1-0.30))
=$338800
Now we will find NPV as under
0
Year-1
Year-2
Year-3
Year-4
Year-5
Year-6
Year-7
Intial cost (as calculated above)
-338800
Annual net cash receipts before tax
105000
105000
105000
105000
105000
105000
105000
Less: Depriciation (350,000/7)
50000
50000
50000
50000
50000
50000
50000
Net cash receipts after dep
but before tax
55000
55000
55000
55000
55000
55000
55000
Deduct:tax @30%
16500
16500
16500
16500
16500
16500
16500
Annual net cash receipts after tax
38500
38500
38500
38500
38500
38500
38500
Add: Depriciation
50000
50000
50000
50000
50000
50000
50000
Annual OCF
88500
88500
88500
88500
88500
88500
88500
Salvage value after tax(18000*70%)
12600
Total cash flows
-338800
88500
88500
88500
88500
88500
88500
101100
PV factor at 16%
1
0.862069
0.74316
0.64066
0.5522911
0.47611
0.4104423
0.3538295
-338800
76293.1
65769.9
56698.2
48877.762
42136
36324.14
35772.165
NPV
23071.293
IRR
18.25%
NPV of the project is $23071
____________________________________________________________
2
internal rate of return of this investment opportunity
IRR
0=388,000+88500/(1+r)1+88500/(1+r)2+88500/(1+r)3+88500/(1+r)4+88500/(1+r)5+88500/(1+r)6+101100/(1+r)7
Solving this equation by trial and error method we get
IRR=18.25%
___________________________________________________
3
Would you recommend that the contract be accepted?
Answer: Yes
0
Year-1
Year-2
Year-3
Year-4
Year-5
Year-6
Year-7
Intial cost (as calculated above)
-338800
Annual net cash receipts before tax
105000
105000
105000
105000
105000
105000
105000
Less: Depriciation (350,000/7)
50000
50000
50000
50000
50000
50000
50000
Net cash receipts after dep
but before tax
55000
55000
55000
55000
55000
55000
55000
Deduct:tax @30%
16500
16500
16500
16500
16500
16500
16500
Annual net cash receipts after tax
38500
38500
38500
38500
38500
38500
38500
Add: Depriciation
50000
50000
50000
50000
50000
50000
50000
Annual OCF
88500
88500
88500
88500
88500
88500
88500
Salvage value after tax(18000*70%)
12600
Total cash flows
-338800
88500
88500
88500
88500
88500
88500
101100
PV factor at 16%
1
0.862069
0.74316
0.64066
0.5522911
0.47611
0.4104423
0.3538295
-338800
76293.1
65769.9
56698.2
48877.762
42136
36324.14
35772.165
NPV
23071.293
IRR
18.25%
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