Steve is a contract carrier for the United States PostalService. He has been hauling mail for nearly thirty years. Hiscurrent contract is to haul mail between 20 cities in the elevenwestern states. Steve currently has a fleet of 16 tractors andemploys over 20 drivers. He does not own any trailers as all of thetrailers are owned by the Postal Service. Steve’s drivers drivescheduled routes between the cities.
The Postal Service has just awarded Steve an additional contractthat will require Steve to purchase six new tractors. He competedaggressively for the contract and spent a total of $45,000 in coststo prepare and submit the bid. Steve has narrowed his decision ofwhich truck to buy down to two choices. He can purchase Volvotractors or Kenworth tractors. The Volvo tractors would cost$285,000 each where the Kenworth would only cost $255,000 each.Both models would be depreciated to zero over 5 years usingstraight-line depreciation.
The Postal Service contract pays Steve $2.85 per mile. Costsassociated with each new tractor include wages for the drivers at$80,000 per truck per year and regular service and maintenance at acost of $1,750 per month per truck. Fuel costs vary as Volvo ismore fuel-efficient than the Kenworth. Assume the tractors will bedriven 105,000 miles per year and diesel costs will average about$3.25 per gallon. The Volvo is expected to get 3.6 miles per gallonwhile the Kenworth will get 3.3 miles per gallon. Insurance andlicensing is expected to cost $6,000 per truck per year and is thesame for both trucks.
Both models will require a complete engine overhaul at 300,000miles and Steve estimates that this will be during the third yearof ownership. The cost of an overhaul on the Volvo is estimated at$45,000 per truck while the cost on the Kenworth is estimated at$52,000 per truck. All other maintenance costs are believed to bethe same for each tractor.
Steve expects to keep the trucks for six years after which timehe will sell them. He will not overhaul the tractors in year 6 asit will not increase their value. He predicts that he will be ableto sell the Volvo’s for $60,000 each, but the Kenworth will beworth only $50,000 each. Steve’s cost of capital is 14%. Thecompany is in the 34% tax bracket.
When Steve got started in the business his first truck was aVolvo. While they cost more Steve believes that they are a bettertruck and he love’s the sleek and powerful look of a Volvo. Becauseof this he is leaning towards buying the Volvo tractors. But afterhearing that you have learned about capital budgeting in yourFinance class at UVU he wants to take advantage of your expertise.Steve has asked you to analyze his choices and give him some adviceon what he should do.
Prepare an analysis and professional report for Steve thatincludes the following items:
1. Determine thecash flows associated with the different trucks for each year ofthe project.
2. Calculate thePB period, Discounted PB, IRR, and NPV for the two alternatives.Explain to Steve what the different methods mean and how he can usethem to help him make a decision.
