Chapter 16, Problem 59C

The board of education for the Central Catskill School District is considering the acquisition of several minibuses for use in transporting students to school. Five of the school district’s bus routes are under-populated, with the result that the full-size buses on those routes are not fully utilized. After a careful study, the board has decided that it is not feasible to consolidate these routes into fewer routes served by full-size buses. The area in which the students live is too large for that approach, since some students’ bus ride to school would exceed the state maximum of 45 minutes.

The plan under consideration by the board is to replace five full-size buses with eight minibuses, each of which would cover a much shorter route than a full-size bus. The bus drivers in this rural school district are part-time employees whose compensation costs the school district $18,000 per year for each driver. In addition to the drivers’ compensation, the annual costs of operating and maintaining a full-size bus amount to $50,000. In contrast, the board projects that a minibus will cost only $20,000 annually to operate and maintain. A minibus driver earns the same wages as a full-size bus driver. The school district controller has estimated that it will cost the district $15,250, initially, to redesign its bus routes, inform the public, install caution signs in certain hazardous locations, and retrain its drivers.

A minibus costs $27,000, whereas a full-size bus costs $90,000. The school district uses straight-line depreciation for all of its long-lived assets. The board has two options regarding the five full-size buses. First, the buses could be sold now for $15,000 each. Second, the buses could be kept in reserve to use for field trips and out-of-town athletic events and to use as backup vehicles when buses break down. Currently, the board charters buses from a private company for these purposes. The annual cost of chartering buses amounts to $30,000. The school district controller has estimated that this cost could be cut to $5,000 per year if the five buses were kept in reserve. The five full-size buses have five years of useful life remaining, either as regularly scheduled buses or as reserve buses. The useful life of a new minibus is projected to be five years also.

Central Catskill School District uses a hurdle rate of 12 percent on all capital projects.

Required:

1. 1. Think about the decision problem faced by the board of education. What are the board’s two main alternatives?
2. 2. One of these main alternatives has two options embedded within it. What are those two options?
3. 3. Before proceeding, check the hint given at the end of the chapter, which explains and diagrams the school board’s alternatives. Suppose the board of education chooses to buy the minibuses. Prepare a net-present-value analysis of the two options for the five full-size buses. Should these buses be sold now or kept in reserve?
4. 4. From your answer to requirement (3), you know the best option for the board to choose regarding the full-size buses if the minibuses are purchased. Now you can ignore the other option. Prepare a net-present-value analysis of the school board’s two main alternatives: (a) continue to use the full-size buses on regular routes or (b) purchase the minibuses. Should the minibuses be purchased?
5. 5. Compute the internal rate of return on the proposed minibus acquisition.
6. 6. What information given in this case was irrelevant to the school board’s decision problem? Explain why the information was irrelevant.
7. 7. Independent of requirements (1) through (6), suppose the NPV analysis favors keeping the full-size buses. Michael Jeffries, the business manager for the Central Catskill School District, was prepared to recommend that the board not purchase the minibuses. Before doing so, however, Jeffries ran into a long-time friend at the racquet club. Peter Reynolds was the vice president for sales at a local automobile dealership from which the minibuses would have been purchased. Jeffries broke the bad news about his impending recommendation about the minibuses to his friend. The two talked for some time about the pros and cons of the minibus alternative. Finally, Reynolds said, “Michael, you and I go back a long time. I know you’re not paid all that well at the school district. Our top financial person is retiring next year. How would you like to come to work for the dealership?”

“That’s pretty tempting, Peter. Let me think it over,” was Jeffries’ response.

“Sure, Michael, take all the time you want. In the meantime, how about rethinking that minibus decision? It’s no big deal to you, and I could sure use the business.”

“But Peter, I told you what the figures say about that,” responded Jeffries.

“Come on, Michael. What are friends for?”

Discuss the ethical issues in this situation. What should Michael Jeffries do?

To determine

Identify the two main alternatives for the board of education.

Explanation of Solution

The two main alternatives for the board of education are as follows:

(i)  Usage of full-size buses on regular routes

(ii) Usage of minibuses on regular routes

To determine

Identify the two options that is embedded within one of the two main alternatives.

Explanation of Solution

There are two options available for the full size buses, if the board of education decided to use minibuses, which are as follows:

1. (i) Sell full size-buses
2. (ii) Keep full size-bus in reserve

To determine

Prepare a net-present-value analysis for the two options for the full-size buses, and determine whether these buses should be kept in reserve or sold now.

Explanation of Solution

Net present value method (NVP): Net present value method is the method which is used to compare the initial cash outflow of investment with the present value of its cash inflows. In the net present value, the interest rate is desired by the business based on the net income from the investment, and it is also called as the discounted cash flow method.

(a) Sell 5 full-size buses:

5 buses could be sold for $15,000 each. So, the sales proceeds will be $\left(\$15,000\times 5\text{ buses}\right)$ $75,000.

Note: No discounting is required for determining the net present value in this case, because the buses are sold now (time 0).

(b) Keep buses in reserve:

Particulars	Amount
Annual savings on bus charter fees $\left(\$30,000-\$5,000\right)$	$25,000
Annuity discount factor	$\times$ 3.605
Present value of savings	$90,125

Table (1)

Note: Annuity discount factor are taken from Table IV of Appendix A, where r = 0.12 and n=5.

Decision:

The present value of savings earned from keeping buses in reserve is $90,125.

The present value of savings earned from sale of buses is $75,000.

Based on the present value of savings, the board has to keep the full-size buses in reserve, as its net present value is greater than sale option.

To determine

Prepare a net-present-value analysis of the school board’s two main alternatives, and determine whether the minibuses should be purchased.

Explanation of Solution

Prepare a net-present-value analysis of minibus purchase decision.

Particulars	Amount
Incremental annual cost of compensation for bus drivers if minibuses are used $\left(\$18,000\times 3\text{ more buses required}\right)$	($54,000)
Incremental annual maintenance and operating costs if minibuses are used $\left[\left(\$20,000\times 8\right)-\left(\$50,000\times 5\right)\right]$	$90,000
Incremental annual cash flow (favors minibuses)	$36,000
Annuity discount factor	$\times$ 3.605
Present value of incremental annual cash flows	$129,780
Cost of redesigning bus routes, retraining drivers, etc. (time 0)	($15,250)
Acquisition cost of minibuses $\left(\$27,000\times 8\right)$	($216,000)
Present value of savings on bus charter fees, if minibuses are purchased	$90,125
Net present value	($11,345)

Table (2)

Note: Annuity discount factor is taken from Table IV of Appendix A, where r = 0.12 and n=5.

In the above incremental cost analysis, parentheses indicate cash flows favoring the full-size bus alternatives. Thus, the minibuses should not be purchased.

To determine

Determine the internal rate of return on the proposed minibus acquisition.

Explanation of Solution

Step 1: Calculate the annual cost savings if the minibuses are used.

Particulars	Amount
Annual savings on bus charter fees $\left(\$30,000-\$5,000\right)$	$25,000
Annual incremental maintenance and operating costs $\left[\left(\$20,000\times 8\right)-\left(\$50,000\times 5\right)\right]$	$90,000
Annual incremental cost of compensation for bus drivers $\left(\$18,000\times 3\text{ more buses required}\right)$	($54,000)
Total annual cost savings if minibuses are used	$61,000

Table (3)

Step 2: Calculate the initial cost if the minibuses are purchased.

Particulars	Amount
Cost of redesigning bus routes, retraining drivers, etc.	($15,250)
Acquisition cost of minibuses $\left(\$27,000\times 8\right)$	($216,000)
Initial cost	$231,250

Table (4)

Step 3: Calculate the internal rate of return.

$\begin{array}{c}\text{Internal rate of return = }\frac{\text{Initial cost}}{\text{Annual cost savings}}\\ =\frac{\$231,250}{\$61,000}\\ =3.791\end{array}$

3.791 factor lies in the 10% column of the 5-year row of Table IV in Appendix A, thus the IRR on the minibus alternative is 10%.

To determine

Identify the information in this case, which is not relevant to the board’s decision problem, and explain the reason for the information was not relevant.

Explanation of Solution

The cost of purchasing a full-size bus ($90,000) is immaterial, since the board is not expecting the purchase of any full-size buses. The depreciation method (straight-line) is also irrelevant, because the depreciation expense is not a cash flow. The NPV and IRR methods focus on cash flows.

To determine

Discuss the ethical issue and suggest the preferable action for Person MJ.  

Explanation of Solution

Person PR is the vice president of the automobile dealership for sales, where his action is inappropriate. Person PR is not supposed to pressure his friend to recommend that the minibuses be purchased. He should search for a most qualified individual for appointing in the financial job at the dealership, but he offered that job to his friend for doing some favor for him.

Ethical standards demand that Person MJ decline to alter his recommendation to the school board. The NPV analysis indicates that the full-size bus option is preferable, and he should recommend accordingly.