ADK Delivery is a small company that transports business packages between San Francisco and Los Angeles. It operates a fleet of small vans that moves packages to and from a central depot within each city and uses a common carrier to deliver the packages between the depots in the two cities. ADK recently acquired approximately $3 million of cash capital from its owners, and its president, Frank Hobb, is trying to identify the most profitable way to invest these funds.
Travis Lard, the company's operations manager, believes that the money should be used to expand the fleet of city vans at a cost of $540,000. He argues that more vans would enable the company to expand its services into new markets, thereby increasing the revenue base. More specifically, he expects cash inflows to increase by $210,000 per year. The additional vans are expected to have an average useful life of four years and combined salvage value of $75,000. Operating the vans will require additional working capital of $30,000, which will be recovered at the end of the fourth year.
In contrast, Kay Osmond, the company's chief accountant, believes that the funds should be used to purchase large trucks to deliver the packages between the deposts in the two cities. The conversion process would produce continuing improvement in operating savings with reductions in cash outflows as the following.
Year 1 Year 2 Year 3 Year 4
$120,000 $240,000 $300,000 $330,000
The large trucks are expected to cost $600,000 and to have a four-year useful life and a $60,000 salvage value. In addition to the purchase price of the trucks, up-front training costs are expected to amount to $12,000. ADK Delivery's management has established a 16% desired rate of return.
Required
a. Determine the net present value of the two investment alternatives.
b. Calculate the present value index for each alternative.
c. Indicate which investment alternative you would recommend. Explain your choice.