10212-10-27FPP

AID: 1825 | 16/10/2013

Given Information:

Capital investment in Truck X and Truck Y is given $50,000 and $64,000

Maintenance cost of Truck X and Truck Y is given as $6,000 and $5,000
Useful life of Truck X and Truck Y is given as 6 years and 6 years respectively
Reduction in fire damage in Truck X and Truck Y per year is given as $20,000
and $22,000.
Money is to be borrowed at 12 percent per year

Incremental investment analysis

Incremental investment required for Truck X, it can be calculated using following
formula:
Annual value X Reduction in fire damage Y Reduction in fire damage X

(1)
Substitute the respective values in Equation (1), this is done below:
Annual value X 22, 000 20, 000
2, 000
Incremental investment required for Truck Y, it can be calculated using following
formula:
r 1 r n

Annual value X CIY CI X

OCY CI X
1 r n 1

(2)

Where
CIY
= Capital investment of Truck Y
CI X
= Capital investment of Truck X
OCY
= Operating and maintenance cost of Truck Y
OC X
= Operating and maintenance cost of Truck X
r = rate of interest
n = number of years
Substitute the respective values in Equation (2), this is done below:
0.12 1 0.12 6
Annual value 64, 000 50, 000
5, 000 6, 000
1 0.12 6 1

6
0.12 1.12
14,000
1, 000
1.12 6 1

0.12 1.9738
14, 000

1, 000
1.9738 1
0.236856
14, 000
1, 000
0.9738
14, 000 0.2432 1, 000
3,404.8 1,000
2,405
Hence, change in the annual value of Truck Y is calculated as 2,405.
Conventional change in B/C ratio
Conventional Benefit cost ratio can be calculated using following formula:
B / C

Annual value of Truck X

Annual value of Truck Y

2,000
2,405
0.83

Conclusion
Incremental BC ratio is less than one. Hence, X is justified and option b is correct.