Economics
Art’s Rental Equipment provides construction equipment, trailers, tools, etc., on short-term rentals. Historically, the owner (Art) has paid full price at the time of purchase for all the items that he rents out. However, he now wants to consider considering acquiring those items by either by leasing them or paying for them over time. He has decided to use the purchase of a large bulldozer with a list price of $720,000 as a test case.
The following are three options for obtaining a new bulldozer that Art developed after negotiation with the manufacturer:
1. Pay in full at the time of sale at an amount equal to the list price less a 5% discount for paying in cash.
2. Pay for the new bulldozer with a four-year loan. In this case, Art would be required to make an initial down payment of 25% of the list price and then pay off the balance in four uniform annual payments based on an APR of 8.49%. (1)
3. Lease a new bulldozer for an eight-year term at a cost of $124,000 per year, each year paid in advance. (2)
If the bulldozer is leased, it must be returned to the manufacturer at the end of the lease period. On the other hand, if Art purchases the bulldozer using either of the first two options, he will own it and, thus, could sell it for its salvage value when appropriate. Art estimates that the salvage value would be $360,000 after four years and $180,000 after eight years. These estimates are based on the fact that Art expects a bulldozer to have a useful life of eight years. Thus, Art will definitely replace the bulldozer after eight years of use but he also would be willing to replace it with a new one after four years if it were to be cost-effective to do so.
Regardless of how the bulldozer is obtained, operating and maintenance costs will be incurred every year; these are expected to start at $18,000 in the first year and increase by 10% each year thereafter. And whether the bulldozer is purchased or leased, it also must be insured for theft, catastrophic damage, and liability at a cost of $9,600 each year. On the plus side, the bulldozer is expected to generate a rental income of $200,000 every year.
What would you recommend Art to do, and why? In developing your recommendation, be sure to clearly:
– Identify all the alternatives you will be comparing;
– If needed, state any additional assumptions you need to make and indicate why you think these are both necessary and reasonable;
– Develop and display a table that depicts the net cash flows associated with each alternative being compared;
– Compare the alternatives on an appropriate basis (i.e., using either a present worth analysis or an annual cash flow analysis) using an interest rate of 16% to account for the time value of money. (3)
– Show or explain your work; and
– Clearly state your final recommendation.
(1) Annual payments are assumed here to help simplify your calculations. While a real-world company would almost surely pay off a loan with monthly payments, experience suggests that the assumption of annual payments should not have a substantial impact substantial on the results of the analysis here.
(2) Like most rental or lease agreements, the first year’s rental fee is due in advance. Thus, the rental fee for the first year is due at the end of year 0, the fee for the second year is due at the end of year 1, and so on.
(3) See the example in the section entitled “Analyzing Loans” starting on page 212 of the course textbook
