Question

How much would an owner be willing to invest to improve the fuel efficiency of a car from 20 mpg to 40 mpg? The cost of gasoline will be $3 per gallon over the 15-year life of the car. The owner plans to drive 10,000 miles each year. The owner expects to receive a 5% return on investment whenever they make an investment.

Answer 1

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Calculation of total cost per year when fuel efficiency is 20 mpg:

Number of gallons required = 10,000 miles / 20 mpg

= 500 gallons

Total Cost for 500 gallons = 500 gallons * $3 per gallon

= $1,500

Calculation of total cost per year when fuel efficiency is 40 mpg:

Number of gallons required = 10,000 miles / 40 mpg

= 250 gallons

Total Cost for 500 gallons = 250 gallons * $3 per gallon

= $750

Cost saving per year if fuel efficiency is improved = $1,500 - $750

= $750 per year

Now an owner would be willing to invest the present value of savings he is going to save over 15 years at

5% rate.

Present Value = Savings per year * Present Value of Annuity at 5% for 15 years.

= $750 per year * 10.380

= $7,785

$7,785 is the required amount the owner shall be willing to invest.