Gail Dribble is a financial analyst at Hill Propane Distributors. Gail must provide a financial analysis of the decision to replace a truck used to deliver propane gas to residential customers.
Given its age, the truck will require increasing maintenance expenditures if the company keeps it in service. Similarly, the market value of the truck declines as it ages. The current market value of the truck, as well as the market value and the required maintenance expenditures for each of the next four years, appears below.
|
Year
|
Market Value
|
Maintenance Cost
|
|
Current
|
$ 7,000
|
$ 0
|
|
1
|
5,500
|
2,500
|
|
2
|
3,700
|
3,600
|
|
3
|
0
|
4,500
|
|
4
|
0
|
7,500
|
The company can purchase a new truck for $40,000. The truck will last fifteen years and will require end-of-year maintenance expenditures of $1,500. At the end of fifteen years, the new truck's salvage value will be $3,500.
a. Calculate the equivalent annual cost (EAC) of the new truck. Use a discount rate of 9 percent.
b. Suppose the firm keeps the old truck one more year and sells it then rather than now. What is the opportunity cost associated with this decision? What is the present value of the cost of this decision as of today? Restate this cost in terms of year-1 dollars.
c. Based on your answers to (a) and (b), is it optimal for the company to replace the old truck immediately?
d. Suppose the firm decides to keep the truck for another year. Gail must analyze whether replacing the old truck after one year makes sense or whether the truck should stay in use another year. As of the end of year 1, what is the present value of the cost of using the truck and selling it at the end of year 2? Restate this answer in year-2 dollars. Should the firm replace the truck after two years?
e. Suppose the firm keeps the old truck in service for two years. Should it replace it rather than keep it in service for the third year?