Prestige Auto Care is considering the purchase of a new tow truck. The garage currently has no tow truck, and the $60,000 price tag for a new truck would be a major expenditure for it. Jenna Lind, owner of the garage, has compiled the following estimates in trying to determine whether she should purchase the tow truck:
Initial cost..........................................$60,000
Estimated useful life..............................8 years
Net annual cash flows from towing.............$8,000
Overhaul costs(endofyear4)......................$5,000
Salvage value......................................$15,000
Jenna's good friend, Reid Shaw, stopped by. He is trying to convince Jenna that the tow truck will have other benefits that Jenna has not even considered. First, he says, cars that need towing need to be fixed. Thus, when Jenna tows them to her facility, her repair revenues will increase. Second, he notes that the tow truck could have a plow mounted on it, thus saving Jenna the cost of plowing her parking lot. (Reid will give her a used plow blade for free if Jenna will plow Reid's driveway.) Third, he notes that the truck will generate goodwill; that is, people who are rescued by Jenna and her tow truck will feel grateful and might be more inclined to use her service station in the future, or buy gas there. Fourth, the tow truck will have "Prestige Auto Care" on its doors, hood, and back tailgate-a form of free advertising wherever the tow truck goes.
Reid estimates that, at a minimum, these benefits would be worth the following:
Additional annual net cash flows from repair work..........................$3,000
Annual savings from plowing........................................................500
Additional annual net cash flows from customer goodwill..................1,000
Additional annual net cash flows resulting from free advertising.............500
The company's cost of capital is.....................................................9%
Instructions
(a) Calculate the net present value, ignoring the additional benefits described by Reid. Should Jenna purchase the tow truck?
(b) Calculate the net present value, including the additional benefits suggested by Reid. Should Jenna purchase the tow truck?
(c) Suppose Reid has been overly optimistic in his assessment of the value of the additional benefits (perhaps because he wants his driveway plowed). At a minimum, how much would the additional benefits have to be worth in order for Jenna to purchase the truck?