Question

Assume that Wal-Mart Stores, Inc. has decided to surface and maintain for 10 years a vacant lot next to one of its stores to serve as a parking lot for customers. Management is considering the following bids involving two different qualities of surfacing for a parking area of 11,300 square yards.

Bid A: A surface that costs $5.50 per square yard to install. This surface will have to be replaced at the end of 5 years. The annual maintenance cost on this surface is estimated at 25 cents per square yard for each year except the last year of its service. The replacement surface will be similar to the initial surface.

Bid B: A surface that costs $10.25 per square yard to install. This surface has a probable useful life of 10 years and will require annual maintenance in each year except the last year, at an estimated cost of 10 cents per square yard.

Compute present value of the bids. You may assume that the cost of capital is 10%, that the annual maintenance expenditures are incurred at the end of each year, and that prices are not expected to change during the next 10 years. (Round factor values to 5 decimal places, e.g. 1.25124 and final answer to 0 decimal places, e.g. 458,581.)

Present value of outflows for Bid A $:

Present value of outflows for Bid B $:

Which bid should be accepted by Wal-Mart.

Answer 1

Solution:

Bid A:

Initial cost of surface = 11300 * $5.50 = $62,150

Replacement cost after 5 years = $62,150

Annual maintenance cost = 11300*0.25 = $2,825 for year 1 to year 4 and year 6 to year 9

Present value of outflows - Bid A = ($62,150) + ($62,150 * PV Factor at 10% for 5th period) + ($2,825 * Cumulative PV Factor at 10% for first 4 periods) + ($2,825 * Cumulative PV Factor at 10% for 6th to 9th period)

$62,150 + ($62,150 * 0.62092) + ($2,825 * 3.16986) + ($2,825 * 1.96823) = $115,255

Bid B:

Surface cost = 11300 * $10.25 = $115,825

Annual maintenance cost = 11300 * $0.10 = $1,113 for year 1 to year 9

Present value of outflows for Bid B = $115,825 + ($1,113 * Cumulative PV Factor at 10% for 9 periods)

= $115,825 + $1,113 * 5.75902 = $122,235

As present value of cash outflows of Bid A is lower than Present value of cash outflows for Bid B therefore wal mart should accept Bid A.