Question

A transit bus was purchased two years ago by the company for $200,000. Today, a similar bus can be purchased for $175,000. The newest bus will save the company $10,000 per year in operational costs compared to the bus purchased two years ago. Each bus has an estimated useful life of five years and will be used 100,000 kms. per year. If the new bus is purchased, the maintenance contract with the seller will be reduced from $20,000 per 100,000 km. of use to $18,000. The bus can be sold for $140,000 in one year’s time. In the meantime, it will be used as a temporary replacement vehicle for out-of-service buses.

Question: Calculate the maximum purchase price that the Company would be willing to pay for the new bus if the discount rate is 10%. Assume no income taxes apply, and that the maintenance contract and operational costs are paid at each year-end. State any additional assumptions you make.

Answer 1

Maximum price that would be paid is equal to present value of future cash flow
Annual cash inflow
Saving in operating cost	$               10,000
Reduction in maintenance cost	$                 4,000
(100000 km/5 years )/10000* ($20000-18000)
Total	$               14,000
Add: after one year's sell price	$           1,40,000
Total cash flow at one year end	$           1,54,000
Present value factor for 1 year at 10%	0.90909
PV of cash flow	$           1,40,000
($154000*0.90909)
Therefore the maximum price that can be paid for each bus would be $140000

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