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- July 26th 2009, 06:09 AM #1

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## To buy or not to buy?

Chaotic Industries is considering an investment in a fleet of 10 delivery vans to take its products to customers. The vans will cost $15,000 each to buy, payable immediately. The annual maintenance and operating costs are expected to total $20,000 for each van, including the driver’s salary. The vans are expected to operate successfully for six years, at the end of which period they will all be sold, with disposal proceeds expected to be $3,000 per van. At present, the business uses a commercial carrier for all of its deliveries. It is expected that this carrier will charge a total of $230,000 each year for the next five years to undertake the deliveries. The Company’s discount rate is 8%. As the financial manager of Chaotic, would you recommend this investment?

Im not even sure where to start, although somethin tells me Im missing something. Thanks.

Ibrox

- July 26th 2009, 07:11 AM #2

- July 26th 2009, 09:26 AM #3

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- July 26th 2009, 10:42 AM #4

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ibrox, check the wording of the original problem carefully. According to your posting, the annual cost to Chaotic under the "no buy" decision is $230K for each of the next

**five**years, using the outsourced carrier service. Should that actually be**six**years (matching the expected service life of the proposed trucks--pretty typical for a question like this)?

By assuming that it's supposed to be $230K for the next__six__years, then the present value of the "purchase" decision is a positive $7,591, just as Wilmer has computed.

Best regards,

- July 26th 2009, 03:16 PM #5

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- July 28th 2009, 10:08 AM #6

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- July 28th 2009, 02:00 PM #7

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Ok, I figured it out, can someone check my work?

**Vans - $15,000 each -> 10 vans will be purchased, so $15,000 x 10 = $150,000**

**Maintenance cost - $20,000 each -> again for 10 vans it’s $20,000 x 10 = $200,000**

**Life of each van = 6 years**

**Salvage value = $3,000 x 10 vans = $30,000**

**Cost of commercial carrier service = $230,000 each year x 5 years = $1,150,000**

**Discount rate – 8%**

**For buying the vans**

**$324,074.07 = ($150,000 [van cost] + $200,000 [maintenance cost] )/1.08 [discount rate]**

**$171,467.76**=**$200,000/1.08^2**

**$158,766.45 = $200,000/1.08^3**

**$147,005.97**=**$200,000/1.08^4**

**$136,116.64 = $200,000/1.08^5**

__+$107,128.84____=__**$200,000 - $30,000 [salvage value]/1.08^6**

**$1,044,559.73 grand total**

**For the outsourcing option, we are going to use the following formula to get the answer quicker:**

**Annuity present value = dollars per period [C] x (1 – 1/(1+r)^t)/ r**

**= $230,000 x (1 – 1/1.08^5)/0.08**

**= $230,000 x (0.3194)/0.08**

**= $230,000 x 3.9925**

**= $918,275**

**Now, because of differing services lives, we have to figure out equivalent annual cost:**

**NPV of costs = EAC x annuity factor**

**Annuity factor simply is: (1 – 1/1+r^t)/r -> which is 3.9927**

**$918,275 = 3.9927EAC**

**$229,988.48 = EAC**

**For the in-house (van) option, it’s**

**NPV of costs = EAC x annuity factor**

**Annuity factor = 1-1/1+r^t/r**

**= (1-1/1+.08^6)/.08**

**= 4.6229**

**NPV of costs = EAC x annuity factor**

**$1,044,559.73 = 4.6229EAC**

**$225,953.35 = EAC**

**Based on the analysis, we should purchase the vans as it effectively costs $225,953.35 a year against the $229,988.48 for outsourcing.**

- July 28th 2009, 05:54 PM #8

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