New College Minibus: Hire or Buy? Report

Abstract

HCT College is currently experiencing a decision problem on whether to buy or hire a bus. HCT has only two alternatives, to hire or to buy. In this report, information has been collected, analyzed and a conclusion drawn using the Net Present Value Approach (NPV). In this technique, the present value of all cash flows for each year is calculated. In this case, the alternative that results in the least cash outflow is the best alternative to be adopted by the school.

The NPV technique is described by the formulae ∑ C_t/(1+R)^t– C_o, where R is Cost of capital, C_t is cash flow for year t, t is the year, and C_o the present salvage value of the bus at the end of the five years. C_o is only used for ‘buy a bus’ decision’, otherwise, the value is zero.

According to the collected information and analysis were done using NPV, HCT should buy a bus because the school will spend more on hiring than on buying. The school will save $32,972 by choosing to buy and not to hire a bus. This analysis covered five years.

Introduction

In business, the primary responsibility of management is decision-making. The management uses the best technique (at a particular circumstance) to gather information, analysis it, and make the decision that minimizes cost but yield maximum returns (Dabhilkar 22). For instance, the management may be faced with a decision problem on whether to buy or hire a machine. The first step for the management is to analyze the situation and select the best approach to solve the problem (Jones 12).

This report is about a decision problem where HCT College needs to decide whether to buy or hire a bus. Information is gathered and analyzed in an excel sheet using the Net Present Value (NPV) technique. In this technique, the present value of all cash flows for each year is calculated. In this case, the alternative that results in the least expenditure is the best alternative to be adopted by the school (Kimmel et al. 54).

Information Used

The information concerning hiring costs and bus purchase prices was gathered from a UAE motor dealer. The following information was collected and will be used for the analysis.

The Net Present Value (NPV) decision-making technique is used to analyze the data and draw a conclusion.

Written analysis

Alternative 1: Hire a bus

The total cost of hiring a bus is $665 per day (including additional insurance cost of $25) and the total number of days the bus is hired per annum is 65 days. Using this, the total cost for hiring a bus for one year calculated by multiplying $665 by 65; that is $665 x 65 =$43,225

For five years the total cash payments to the bus company will be as follows: $43,225 x 5 = $216,125

The NPV technique will be used to calculate the present value of total cash payments for five years. The NPV approach uses the following formulae:

NPV = ∑ C_t/(1+R)^t (Le Dain et al. 61)

Where,

R = Cost of capital = 6.99%

C_t = cash flow for year t

t= year

Using the above formula,

Year 1= 43,225 /1.0699¹ = 40,401

Year 2 = 43,225 /1.0699² = 37,761

Year 3 = 43,225 /1.0699³ = 35,294

Year 4 = 43,225 /1.0699⁴ = 32,988

Year 5 = 43,225 /1.0699⁵ =30,833

TOTAL

177,278

The present value of the total cash outflows (Present value of total cash used to hire bus) is $177,278

Option B: Buy a bus

The first five years cost will include:

Insurance and servicing costs will be recurring every year for five years

The NPV in this case will be

NPV = ∑ C_t/(1+R)^t – C_o

Where,

R = Cost of capital = 6.99%

C_t = cash flow for year t

t= year

C_o = present salvage value

Using this formula:

Year 1 =84,700/1.0699¹ = 79,166

Year 2 =21,900/1.0699² = 19,132

Year 3 =21,900/1.0699³ = 17,882

Year 4 =21,900/1.0699⁴ = 16,714

Year 5 =(21,900-5,900)/1.0699⁵ = 11,413 note 5,900 is salvage value

TOTAL net present value = 144,307

Conclusion

The total present value cost for five years for hiring bus is $177,278 while the total present value cost for five years for buying the same bus is $144,307.

By buying a bus, the college will save $32,972 per annum as indicated below.

Recommendations

By buying a bus the college will save a total of $32,972. It is therefore advisable for the college to buy.

There are other benefits the college get by buying a new bus, these include:

1. Unlimited access and use of the bus.
2. The bus will become a school property
3. The school can hire out the bus when they are not using it, this will generate an additional income for the school.

Assumptions

1. Hiring cost is inclusive of basic insurance costs. The school takes additional insurance of $25 per day when it hires the bus.
2. There is a registration cost for the bus paid for the first year only if the bus is bought.
3. The cost of insurance and servicing of the bus is paid yearly
4. The driver’s salary and cost of fuel are paid whether the bus is bought or hired. This has been intentionally left out because its inclusion will not make any difference in the analysis.
5. The bus salvage value after five years is 10% of the original cost.
6. The cost of capital used is 6.99%. This is the average rate of lending by ENBD bank (for Development loans).

Works Cited

Dabhilkar, Mandar. “Trade-offs In Make-buy Decisions.” Journal of Purchasing and Supply Management 17.3 (2011): 158-166. Print.

Jones, Tim. Business economics and managerial decision making. Chichester, Eng.: J. Wiley, 2004. Print.

Kimmel, Paul D., Jerry J. Weygandt, and Donald E. Kieso. Financial accounting: tools for business decision making. 4th ed. Hoboken, NJ: John Wiley, 2007. Print.

Le Dain, Marie-Anne, Richard Calvi, and Sandra Cheriti. “Developing An Approach For Design-or-buy-design Decision-making.” Journal of Purchasing and Supply Management 16.2 (2010): 77-87. Print.