1. A firm can lease a truck for 4 years at a cost of $30,000 annually. It can instead buy a truck at a cost of $80,000, with ann
ual maintenance expenses of $10,000. The truck will be sold at the end of 4 years for $20,000. Calculate the equivalent annual annuity to show the better option if the discount rate is 10%.
Option 1 is favored due to: EAC of Instatement option = $30,000 vs. EAC of Purchase option = $37,660. The Equivalent Annual Cost is calculated using: Equivalent Annual Cost = Net Present Value of option / Annuity Factor. We must now compute the present value for each available option.
For Option 1: Present Value = Annual Cash Flow × Annuity Factor. The Annuity Factor is obtained using:
Annuity Factor = (1 - (1+r)^-n) / r.
Plugging in the values, we find:
Annuity Factor = (1 - (1.1)^-4) / 0.1 = 2.487.
Thus, Present Value = $30,000 × 2.487 = $74,610, and the Equivalent Annual Cost amounts to $74,610 / 2.487 = $30,000.
Now for Option 2: Present Value = $80,000 (initial cash outflow) + $20,000 (cash inflow at Year 4) / (1.1)^4.
Present Value = $80,000 + $20,000 / 1.4641 = $80,000 + $13,660 = $93,660, thus EAC = $93,660 / 2.487 = $37,660.
Decision Rule: The least-valued option signifies the most economical choice, which, in this case, is option 1.
Opting for the lease is a more favorable choice. To illustrate, we examine the calculations for both options. First, we calculate the Net Present Value (NPV) for the Lease Option:
Year n Details CF ($) DF=1/(1.1)^n PV ($)
1 - Lease payment (30,000) 0.9091 (27,273)
2 - Lease payment (30,000) 0.8264 (24,793)
3 - Lease payment (30,000) 0.7513 (22,539)
4 - Lease payment (30,000) 0.6830 (20,490)
The NPV for the lease option equals (95,096).
For the Buy Option, we carry out the following calculations:
Year n Details CF ($) DF=1/(1.1)^n PV
0 Purchase cost (80,000) 1.0000 (80,000)
1 Maintenance costs (10,000) 0.9091 (9,091)
2 Maintenance costs (10,000) 0.8264 (8,264)
3 Maintenance costs (10,000) 0.7513 (7,513)
4 Maintenance costs (10,000) 0.6830 (6,830)
Residual value at end of year 4 20,000 0.6830 13,660
The NPV for the buy option results in (98,038).
To determine the equivalent annual annuity (EAA) for each option:
EAA = (r × NPV) / (1 - (1 + r)^-n)
where r is the discount rate per period and n shows the number of periods.
Calculating:
Lease option EAA = (0.1 × -95,096) / (1 - (1 + 0.1)^-4) = -30,000.
Buy option EAA = (0.1 × 98,038) / (1 - (1 + 0.1)^-4) = -30,928.
Since the lease option manifests a lower EAA of $30,000 compared to the buy option's $30,928, the lease is deemed the superior choice.
The best approach for acquiring inputs that have clear and quantifiable quality requirements and necessitate specialized investment is through contracts.
Explanation:
The contract formalizes the arrangement between the buyer and seller, establishing legal conditions and agreed responsibilities. One of the significant benefits is that companies and buyers can concentrate on obtaining what they require as contracts apply to physical goods as well as services, minimizing opportunistic behaviors and underinvestment.
An example is CONASUPO, a Mexican government agency that entered into contracts with ranchers across Mexico to procure their milk production at reduced prices to support numerous low-income households.
Warby Parker is a company specializing in eyewear that produces designer glasses at affordable prices. The company's management believes in the importance of grounding its operations in Corporate Social Responsibility.
Explanation:
Warby Parker is an eyewear manufacturer creating designer glasses that remain budget-friendly. The management asserts that its operations should be based on principles of Corporate Social Responsibility.
