When to replace an asset: Nemo Haulers is considering whether to purchase a new mini tractor for moving furniture within its warehouse. Nemo calculates that its current mini tractor generates $3,100 of cash flow per year. A new mini tractor would cost $3,000 and would provide cash flow of $4,000 per year for five years. What is the equivalent annual cash flow for the new mini tractor (round to the nearest dollar), and should Nemo purchase the new tractor? Assume the cost of capital for Nemo is 10 percent.

Question

Quizplus · Accepted Answer

Using the formula: equivalent annual cash flow = (NPV of investment / annuity factor), we can calculate the equivalent annual cash flow of the new mini tractor:

NPV of investment = - $3,000 + (PV of five years of cash flows) 
PV of five years of cash flows = $4,000/(1.10) + $4,000/(1.10)^2 + $4,000/(1.10)^3 + $4,000/(1.10)^4 + $4,000/(1.10)^5 = $15,158.43 
NPV of investment = -$3,000 + $15,158.43 = $12,158.43

Annuity factor = (1 - 1/(1+0.10)^5)/0.10 = 3.7908

Equivalent annual cash flow = $12,158.43/3.7908 = $3,208.97

Since the equivalent annual cash flow of the new mini tractor is higher than the current mini tractor ($3,208.97 > $3,100), and its cost is lower than the present value of cash flows it generates, Nemo should purchase the new tractor.

Therefore, the best choice is B.

When to Replace an Asset: Nemo Haulers Is Considering Whether