Today is January 1st, 20XX, and your car has recently experienced a mechanical problem. You are considering giving up “old-reliable” and trading it in for a newer model. You are debating between a brand new hybrid-electric car and a brand new conventional gas engine car. However, before making your final decision you decide to take a look at a few factors to decide if a new vehicle will actually save you money over the next 5 years and if so, which vehicle will be the best value.
Your current vehicle (which you own free and clear) is worth $10,000 and is in need of $500 of repairs today. You estimate that the car will cost an additional $500 in repairs every 12 months. (TIP: This is an example of an annuity due situation.) You currently average 25 MPG. The estimated trade-in value for “old-reliable” in 5 years will be $2,000.
The hybrid car you are considering purchasing has a sales price of $35,000 and claims to get 45 MPG. Since the car is new you do not anticipate any additional repair expenses like you do with your older model vehicle. The estimated trade-in value for the hybrid car in 5 years will be $15,000.
The conventional gas-engine vehicle you are considering has a sales price of $25,000 and gets 25 MPG. Like the hybrid model, this car would not require any additional annual repair costs. The estimated trade-in value for the gas-engine vehicle is $11,000 in 5 years.
For both of the new vehicles use the following information:
The dealership is offering you a choice of 0% financing for 60 months or a $5,000 cash discount on the sales price. Your current financial institution (i.e., Bank or Credit Union) is offering a rate of 6% for 60 months on auto loans.
For all vehicles assume the following:
Average cost per gallon of gasoline is $3.50 and we pay for all gas purchased on the last day of the month for all vehicles.
You drive an average of 1,000 miles per month.
Cost of auto insurance and general maintenance (oil changes, state inspections, ect.) are identical for each vehicle and are therefore irrelevant for this exercise.
Assume a discount rate of 5% for all cash flows.
To make your final decision answer the following questions:
A. Which financing offer is better; the 0% offer or taking the cash discount on the sales price and financing at the higher interest rate?
B. What is the true cost of the vehicle and why do you think car dealerships/car companies offer this type of promotion?
C. Build a chart outlining the cash flows including the timing of the cash flows for each vehicle over the 5-year period? Also, keep in mind that for alternatives 2 and 3 you would trade in the old car at current value.
D. Which of the 3 choices offers the highest present value today?
E. Which option would you choose and why?