Capital budgeting case analysis

Hay Taxi should replace the new vehicles after five years. This decision comes about after a capital budgeting analysis that illustrates the different possible scenarios for replacing the vehicles. A net present value calculation was done for each scenario to determine which scenario delivered the highest total net present value over the next six years for the Hay Taxi company. There is little difference between replacing the vehicles after year six, but year five yields a slightly better net present value. It is not recommended that the vehicles are replaced any earlier than this.

The heart of the methodology is the net present value analysis. The net present value calculation takes into account all of the incremental cash flows to this decision. The cash flows in question are the cost of the vehicles, their salvage value, the cost of replacing the batteries should the cars be kept long enough to warrant doing so, the annual maintenance, the tax savings from the depreciation expense and the revenue that the new cabs will generate. The revenue is incremental because our current fleet must be replaced -- we could also choose to shut down the company.

An individual net present value calculation was conducted for each scenario. The following scenarios were tested: Replace the cars after the each year of use, after every other year, after every third year, every fourth year, fifth year and sixth year. By law, the cars must be removed from the fleet after six-year, so these six options are the only one possible.

The net present value was calculated on the basis of a 10% discount rate, and a 30% tax rate as basic assumptions. Revenue was assumed to be $180 per annum with operating expenses of $130,000 per annum. In each calculation, the future cash flows were estimated on the basis of these assumptions. The next step was to discount these future cash flows back to present day dollars. Then, the sum of the present values was calculated, to deliver the net present value.

In general, the net present value over 0 means that the project should be accepted, because it delivers positive value to the company. All six scenarios delivered positive value to the company, which basically tells us that we are running a profitable business. The net present value increased with replacement in years 1-5, the first five scenarios. This is attributable to the high cost of replacing the cars, which is not made up by savings elsewhere. Thus, the most desirable scenarios that delivered the highest NPV to the company were the ones farthest out. The methodology for selecting the best option was simply to select the alternative that had the highest net present value. This was the fifth option, which is to replace the vehicles every five years.

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