Isaac’s Auto Repair is considering the purchase of a new tow truck. The garage doesn’t currently have a tow truck, and the $65,000 price tag for a new truck would represent a major expenditure for the garage. Isaac Mayer, owner of the garage, has compiled the following estimates in trying to determine whether to purchase the truck.
Initial cost ..............$65,000
Estimated useful life ..........8 years
Net annual cash inflows from towing .....$9,600
Overhaul costs (end of year 4) ........$7,000
Salvage value ...............$16,000
Isaac’s good friend, Brad Jolie, stopped by. He is trying to convince Isaac that the tow truck will have other benefits that Isaac hasn’t even considered. First, he says, cars that need towing need to be fixed. Thus, when Isaac tows them to his facility his repair revenues will increase. Second, he notes that the tow truck could have a plow mounted on it, thus saving Isaac the cost of plowing his parking lot. (Brad will give him a used plow blade for free if Isaac will plow Brad’s driveway.) Third, he notes that the truck will generate goodwill; that is, people who are rescued by Isaac and his tow truck will feel grateful and might be more inclined to use his service station in the future or buy gas there. Fourth, the tow truck will have “Isaac’s Auto Repair” on its doors, hood, and back tailgate—a form of free advertising wherever the tow truck goes.
Brad estimates that, at a minimum, these benefits would be worth the following.
Additional annual net cash flows from repair work ........$2,600
Annual savings from plowing ................600
Additional annual net cash flows from customer “goodwill” ....1,200
Additional annual net cash flows resulting from free advertising ...500
The company’s cost of capital is 10%.
Instructions
(a) Calculate the net present value, ignoring the additional benefits described by Brad.
Should the tow truck be purchased?
(b) Calculate the net present value, incorporating the additional benefits suggested by
Brad. Should the tow truck be purchased?
(c) Suppose Brad has been overly optimistic in his assessment of the value of the additional benefits. At a minimum, how much would the additional benefits have to be worth in order for the project to be accepted?