Least Cost Decisions:
Revenues are not directly involved in some
decisions. For example, a company that does not charge for delivery service
may need to replace an old delivery truck, or a company may be trying to
decide whether to lease or to buy its fleet of executive cars.
In situations
such as these, where no revenues are involved, the most desirable
alternative will be the one that promises the least total cost from the
present value perspective. Hence, these are known as least cost decisions.
To illustrate a least cost decision, consider the following data:
Example:
Val-Tek Company is considering the
replacement of an old threading machine. A new threading machine is
available that could substantially reduce annual operating costs. Selected
data relating to the old and the new machines are presented below:
| |
Old Machine |
New Machine |
| Purchase cost
when new |
$200,000 |
$250,000 |
| Salvage value
now |
30,000 |
-- |
| Annual cash
operating costs |
150,000 |
90,000 |
| Overhaul needed
immediately |
40,000 |
-- |
| Salvage value
in six years |
0 |
50,000 |
| Remaining life |
6 years |
6 years |
| |
|
|
| Val-Tek Company
uses a 10% discount rate |
|
|
Total Cost Approach or Total Cost Method:
Following is the analysis
of the alternatives using total cost approach:
The Total Cost Approach (Lease Cost Decision)
|
Item |
Year(s) |
Amount of Cash Flows |
10% Factor* |
Present Value of Cash Flows |
|
Buy the new machine: |
|
|
|
|
| Initial
investment |
Now |
$(250,000) |
1.000 |
$(250,000)** |
| Salvage
of the old machine |
Now |
30,000 |
1.000 |
30,000** |
| Annual
cash operating cost |
1 - 6 |
(90,000) |
4.355 |
(391,950) |
| Salvage
of the new machine |
Now |
50,000 |
0.564 |
28,200 |
| |
|
|
|
|
| Net present
value |
|
|
|
583,750 |
| |
|
|
|
|
|
Keep the old machine: |
|
|
|
|
|
Overhaul needed now |
Now |
$(40,000) |
1.000 |
(40,000) |
| Annual
cash operating costs |
1 - 6 |
(150,000) |
4.355 |
(653,250) |
| |
|
|
|
|
| present value
of net cash outflows |
|
|
|
$693,250 |
| |
|
|
|
|
| Net present
value in favor of buying the new machine |
|
|
|
$109,500 |
| |
|
|
|
|
| |
|
|
|
|
* All present value factors are from
Future Value and Present
Value Tables page - Table 3 and Table 4.
** These two figures could be netted into a
single $220,000 incremental cost figure ($250,000 - $30,000 = $220,000) |
As shown in the above solution, the new
machine has the lowest total cost when the present value of the net cash
outflow is considered.
Incremental Cost Approach or Incremental Cost Method:
An analysis of the two alternatives using
the incremental cost approach is presented below:
The Incremental Cost Approach (Lease Cost Decision)
|
Item |
Year(s) |
Amount of Cash Flows |
10% Factor* |
Present Value of Cash Flows |
|
Incremental investment to buy the new machine |
Now |
$(210,000) |
1.000 |
$(210,000)** |
| Salvage
of the old machine |
Now |
30,000 |
1.000 |
(30,000)** |
| Salvage
in annual cash operating costs |
1 - 6 |
60,000 |
4.355 |
261,300 |
|
Difference in salvage value in six years |
6 |
50,000 |
0.564 |
28,200 |
| |
|
|
|
|
| Net present
value in favor of buying the new machine |
|
|
|
$109,500 |
| |
|
|
|
|
* All present value factors are from
Future Value and Present
Value Tables page - Table 3 and Table 4.
** These two items could be netted into a
single $180,000 incremental cost figure ($210,000 - $30,000 = $180,000). |
This solution represents the differences
between the alternatives as shown under the total cost approach.
|
In Business
| Trading in that Old Car?
Consumer reports
magazine provides the following data
concerning the alternatives of keeping a four year old Ford Taurus for
three years or buying a similar new car to replace it. The illustration
assumes the car would be purchased and used in suburban Chicago.
| |
Keep the Old Taurus |
Buy a New Taurus |
| Annual
maintenance |
$1,180 |
$650 |
| Annual
insurance |
370 |
830 |
| Annual
license |
15 |
100 |
| Trade-in
value in three years |
605 |
7,763 |
| Purchase
price, including sales tax |
|
17,150 |
Consumer Reports is ordinarily extremely
careful in its analysis, but it has omitted in this case one financial
item that would clearly differ substantially between the alternatives
and hence would be relevant. What is it?
Source: "When to Give Up
on Your Clunker," Consumer Reports, August 2000, pp. 12-16. |
|
