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Determining an Asset's Optimal Economic Life

The Scampini Supplies Company recently purchased a new delivery truck. The new truck cost $22,500, and it is expected to generate net after-tax operating cash flows, including depreciation, of $6,250 per year. The truck has a 5-year expected life. The expected salvage values after tax adjustments for the truck are given below. The company's cost of capital is 10%.

Year Annual Operating Salvage Value
Cash Flow

0 (22,500) 22,500
1 6,250 17,500
2 6,250 14,000
3 6,250 11,000
4 6,250 5,000
5 6,250 0

a. Should the firm operate the truck until the end of its 5-year physical life, or, if not, what is its optimal economic life?

b. Would the introduction of salvage values, in addition to operating cash flows, ever reduce the expected NPV and/or IRR of a project?

Solution Preview

a. As you can see on the attached Excel 97-2003 spreadsheet, the optimal expected net present value is obtained if the truck is sold at the end of Year 3.

b. ...

Solution Summary

Using an Excel 97-2003 spreadsheet, this solution computes the optimal economic life of an asset with a salvage value which changes annually. it also discusses the effect of the salvage value on the asset's internal rate of return and net present value.