Question

Imagine that you own a 5-year old car that was just paid off and refurbished for $4,400. On your next trip, the transmission is severely damaged and must be replaced for $4,000. Assume a life span for your 5-year old vehicle of 10 years (5 years left). In lieu of spending $4,000, you can get a trade-in value of $12,000 (in its current broken condition) towards a new car of $28,000 (including all fees and taxes). Assume a life span for the new vehicle of 10 years.

Show how you would analyze your choices using CFDs. What Planning Horizon would you use? What expenses would you consider? Show CFDs for each alternative and use appropriate symbols – do NOT solve the problem but explain your approach.

Answer 1

Cash flow discounting is a valuable tool used for assessing the different options available. The $4,400 already spent in refurbishing the old car is sunk cost and hence must not be considered. The choice is between $4,000 to be spent for replacement of the transmission and purchase of new car worth $28,000 along with considering the trade in value of $12,000 of the old car.

The planning Horizon to be considered is 10 years since that is the life of the new vehicle. In analysing the choices the fuel and maintenance expenses of the two cars would be considered. Cash flow analysis for the two alternatives are as follows in year 0/ at present

Year	Saving transmission costs	Trade in value of old car	Purchase price of new car
0	4000	12000	-28000

The rest of the years will consider the incremental or decremental maintenance costs as well as fuel costs that would arise by making the choice towards the new car. In the last year, we will also consider the salvage value of the new car.

An appropriate discount rate would be applied to calculate the present value of the cash flows. If the NPV is positive, the choice will be in favor of the new car else not.