What role, if any, do depreciation charges play in the analysis and why?

(Adapted from a problem by S. Zeff.) William Marsh, CEO of Gulf Coast Manufacturing, wishes to know which of two strategies he has chosen for acquiring an automobile has lower present value of cost.

Strategy L. Acquire a new Lexus at the beginning of 2008, keep it until the end of 2013, then trade it in on a new car.

Strategy M. Acquire a new Mercedes-Benz at the beginning of 2008, trade it in at the end of 2010 on a second Mercedes-Benz, keep that for another three years, then trade it in on a new car at the end of 2013.

Data pertinent to these choices appear below. Assume that Marsh will receive the trade-in value in cash or as a credit toward the purchase price of a new car. Ignore income taxes and use a discount rate of 10% per year. Gulf Coast Manufacturing depreciates automobiles on a straight-line basis over 8 years for financial reporting, assuming zero salvage value at the end of 8 years.

a. Which strategy has lower present value of costs?

b. What role, if any, do depreciation charges play in the analysis and why?

Lexus

Mercedes-Benz

Initial Cost at the Start of 2008

$60,000

$45,000

Initial Cost at the Start of 2011

48,000

Trade-in Value

End of 2010

23,000

End of 20131

16,000

24,500

Estimated Annual Cash Operating Costs

Except Major Servicing

4,000

4,500

Estimated Cash Cost of Major Servicing

End of 2011

4,000

End of 2009 and End of 2012

2,500

 

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