Question

Tom expects that the annual maintenance costs (paid at the end of each year) of his older model car to be $2,000 for the coming year, $2,500 for the second year and $3,000 for the third year. The car currently has a market value of $2,700 and he expects this to fall to $2,000 next year, $1000 after the second year, and zero thereafter as it will just fall apart. He has been considering a newer model replacement vehicle that will cost $10,000 to purchase and would be expected to last 8 years, with maintenance costs of $350 in the first year, growing by 50% per year thereafter through the 8th year. Assume all of these costs are real (net of expected inflation) and that future replacement cars with the same real costs are available now as well as into the future. Tom determines that a reasonable real discount rate for this problem is 7%. Help him determine when it would make financial sense to move up to the newer model car. There are four possibilities: now, one year from now, two years from now, or wait until the car dies after its third year. Why did you make your final decision?

Answer 1

Answer:

1) NPV for possibility 1: - $18626

2) NPV for possibility 2: - $19933.29

3) NPV for possibility 3: - $21808.2

4) NPV for possibility 4: - $23911.63

From the NPV analysis, NPV for possibility 1 is the highest. Hence, Tom should sell off his old car today and buy new car.

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