William Marsh, CEO of Gulf Coast Manufacturing, wishes to know which of two strategies he has chosen for acquiring an automobile has lower present value of cost. Strategy L. Acquire a new Lexus at the beginning of 2008, keep it until the end of 2013, then trade it in on a new car. Strategy M. Acquire a new Mercedes Benz at the beginning of 2008, trade it in at the end of 2010 on a second Mercedes Benz, keep that for another three years, then trade it in on a new car at the end of 2013.
Data pertinent to these choices appear below. Assume that Marsh will receive the trade in value in cash or as a credit toward the purchase price of a new car. Ignore income taxes and use a discount rate of 10% per year. Gulf Coast Manufacturing depreciates automobiles on a straight line basis over 8 years for financial reporting, assuming zero salvage value at the end of 8 years.
a. Which strategy has lower present value of costs?
b. What role, if any, do depreciation charges play in the analysis and why?
|
Lexus |
Mercedes Benz |
|
|
Initial Cost at the Start of 2008 |
$60,000 |
$ 45,000 |
|
Initial Cost at the Start of 2011 Trade in Value |
48,000 |
|
|
Trade in Value |
||
|
End of 2010 |
23,000 |
|
|
End of 20131 |
16,000 |
24,500 |
|
Estimated Annual Cash Operating Costs Except Major Servicing |
4,000 |
|
|
Estimated Cash Cost of Major Servicing |
4,500 |
|
|
End of 2011 |
||
|
End of 2009 and End of 2012 |
6,500 |
2,500 |
1At this time Lexus is 6 years old; second Mercedes Benz is 3 years old.