I do not understand this question. Where did the 12000 come from? Can you explain step by step? Answer and explanation is given below the question but I need someone to break it down more so that I can understand it.

Question:

Jeremy Pruitt Ltd is considering the replacement of a delivery truck. The current truck could last for three more years. Operating costs are 5000 per year. We are currently depreciating it at 4000 per year. We could sell it at the end of the three years for 2000 with a book value of zero. If we purchase the new truck for 32000 we could use three year MACRS. We could sell the old truck now for 7000. Operating costs would drop to 1000 per year. We can sell the new truck for 15000 at the end of the third year. The tax rate is 40%. The WACC is 10%. Should we replace the truck?

Answer and Explanation:

Year Zero: Buy the new truck (32000), sell the old truck (7000-12000)*(.6) + 12000 = 9000. This is greater than the cash paid for the old truck because we get a tax reduction for selling at a loss compared to the book value.

Depreciation for the new truck will be 10665.6, 14224, 4739.2, leaving a book value of 2371.2 at the end. Change in tax shield for year one will be (10665.6-4000)*.4=2666.24. In two it will be 4089.6, in three it will be 295.68.

The after tax change in operating cash flow is (0 - - 4000)*(.6) = 2400.

Sell the new truck in year three: (15000-2371.2)*.6 + 2371.2 = 9948.48.

The opportunity cost of not getting to sell the old truck in year three is (2000)*.6=1200

Putting it all together

Year 0: (32000) + 9000 = (23000)

Year 1: 2400 + 2666.24 = 5066.24

Year 2: 2400 + 4089.6 = 6489.6

Year 3: 2400 + 295.68 +9948.48 + (1200) = 11444.16

The NPV of this is (4432.86), so we should not buy.

Throughout our capital budgeting analysis so far, we have assumed that the WACC was a valid discount rate and hurdle rate. This should usually be the case. If a project has substantially different risk than other things the firm is doing, adjust the cost of funds accordingly: raising it above the WACC for project's that are above average risk and vice versa. Try to think of the risk in a portfolio context, a firm is basically just a portfolio of investment projects.