Question

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1) The CFO of a consulting engineering firm is deciding between purchasing Ford Explorers and Toyota 4Runners for company principals. The purchase price for the Ford Explorer will be $30,750. Annual maintenance costs for the Explorer are expected to be $575 per year more than that of the 4Runner. The purchase price for Toyota 4Runners is 35,250 The trade-in values after 3 years are estimated to be 50% of the first cost for the Explorer and 60% for the 4Runner. (a) What is the incremental ROR between the two vehicles? (b) Provided the firm’s MARR is 15% per year, which vehicle should it buy?

Answer 1

In the incremental IRR analysis we find incremental cash flows by deudcting lower first cost project from higher first cost project

Negative convetion is for Cash outflow such as difference in cash flow is if negative.

We have alternatives 'Toyota 4 runner" and "Ford Explorer"out of which Toyota 4 runner have higher initial cost

Now we can Fill the blanks

Resale Value for Toyota=35250*0.6=21150
Resale Value for Ford = 30750*0.5=15375

Process   Toyota Ford Incremental Cash flow
First Cost -35250 -30750 -4500
M&O $/year -x -(575+x) 575
Resale Value 21150 15375 5725
Life, Years 3   3

i% is incremental RoR

We then have Present worth of negative incremental Cash flow equals to Present worth of positive incremental cash flow

0=-4500+575(P/A,i%,3)+5775(P/F,i%,3)

4500=575(P/A,i%,3)+5775(P/F,i%,3)

we get using IRR function from excel that i%=20.53% that is higher than MARR

therefore we can say that preferring higher initial cost project over lower initial cost project is beneficial because incremental RoR (i)>MARR

Therefore Toyota 4 runner should be bought