Welcome to question #1 of our series of Practice Problems. These Practice Problems will put to use the skills and concepts taught in our BizBasics Online courses and will reinforce your learning. If you start quaking in your boots when you read some of these terms (i.e. discount rate, straight-line depreciation, NPV, salvage, et. al.), then make sure you check out our Finance courses to learn all about what they mean and how to apply them.
If you would like to submit a problem that we can use for our Practice Problem series, email us at comments@BizBasicsOnline.com.
In finance, mutual exclusivity means you will do one option or another, but not both.
This is a common situation in finance. There is a particular principle related to mutually exclusive situations. This principle will be discussed near the end of the following example.
A golf course is considering purchasing new golf carts. They have two options. A cart sold by Rinky Dink, Inc is the standard version in the industry. It is battery powered. It is a basic cart with few frills. It is designed with cheaper materials and is anticipated to be replaced in five years. The cost of each basic cart is $5000.
As another option, the golf course is considering Super Duper’s Special Cart. It has a built-in GPS. It is more colorful and gas powered. It is more comfortable. It is just plain cooler than the basic Rinky Dink model. It is also made of better materials and will last eight years. The cost of the Super Duper is $9250.
With the basic cart, they will average 50 rounds per day. The golf course forecasts that the Special Cart will add two additional rounds per day to their revenues because more golfer will desire to play their course. In addition, this will allow them to raise the average green fees from $45 to $47.
Here are some assumptions:
Discount Rate is 12% nominal. Inflation is 3%. Depreciation for both options is five years, using straight-line. Capital Gains Tax is 20%. The income tax rate is 40%. Sixty-four carts are needed for both options.
With rain and Christmas Holiday, the course forecasts 360 days of play each year. Regardless of which option is chosen, the total costs for the course are $600,000 per year, before taxes. That includes all costs like operations, maintenance, salaries, advertising, interest, and grass seed (but I guess that would be under maintenance).
If the basic cart is purchased, the course forecasts a $1000 salvage value in five years. If the Super Duper is purchased, the course predicts a $1500 salvage in eight years. If they sold the Super Duper carts in five years, the salvage would be $2000.
So, here is your mission, if you choose to accept it:
Using Net Present Value, calculate the NPV of each option and select the best choice financially.
There is a kicker for this problem. For Mutually Exclusive situations, you MUST do the NPV on common time frames. For this problem, you can chain the two options for forty years. That means a big NPV timeframe, eight of the five-year option and five of the eight-year option. If it were five and ten years, you could chain the five-year option twice and it would be easier.
However, for this problem, you have another choice. Let’s assume you will salvage both options after five years. The salvage value for the Super Duper cart will be much higher. That keeps it in the same time frame.
For practice, do the NPV wrong forSuperr Duper. Use Eight years and see the overstated NPV. Then do it for five years and compare it to the Rinky Dink option.
Clue 1: You should calculate the after-tax profits for both options, not merely the revenues.
Clue 2: When done properly, the two options are almost equal.
Does this allow the golf course to negotiate with Super Duper?
Do you want to see the answer or compare your calculations??
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