You are on page 1of 7

CASE 16 - 59

I. SUMMARY

The Warringah Central School is considering on replacing its five (5)


full-size buses with eight (8) minibuses in transporting its students to school.
It has been reported that the full-size buses are not used to their full capacity
due to the lack of students in their assigned routes. Notably, the school
deemed that it is not feasible to consolidate these routes, and purchasing
minibuses may just be the solution.
A comparison of the costs associated with the full-size buses and the
minibuses is presented below.

COSTS

5 FULL-SIZE

8 MINIBUSES

Salaries per

BUSES
$ 18,000 per

$ 18,000 per

driver
Maintenance per

year
$ 50,000 per

year
$20,000 per

bus

year
$90,000 per

year
$27,000 per

bus

bus
$ 15,250

Acquisition cost
Other costs

Furthermore, the school is also considering whether the full-size buses


should be sold or reserved for future purposes (like field trips) if it decides to
abandon their use. Currently, the school charters the buses used in field trips
from a private company for $30,000 annually. It has been estimated that the
costs will be cut to $5,000 each year if the school decides to keep the buses
for future use. On the other hand, it has been estimated that the buses can
be sold for $15,000 each.
Other information relating to the case is enumerated below:
1. The full-size buses have a remaining five year-life. If minibuses will
be purchased, their estimated life will also be equal to five years.
2. The straight line method of depreciation is the method the school
uses in depreciating its equipment.
3. The school uses a hurdle rate of 12% on all its capital projects.

II. REQUIREMENTS
1. Identify the schools two main alternatives.
2. Distinguish the two other options of the school branching from one
of the main alternatives.
3. Prepare a net-present value analysis of the two options for the five
full-size buses.
4. Prepare a net-present value analysis of the two main alternatives,
taking into account the decision derived from item 3.
5. Compute for the internal rate of return on the proposed minibus
acquisition.
6. Identify which information in the case is irrelevant. Explain the
reason behind the claim.
III. DISCUSSSION
1. Identify the schools two main alternatives.
The schools two main alternatives are (1) retaining its five fullsize buses, and (2) purchasing eight minibuses.
2. Distinguish the two other options of the school branching from
one of the main alternatives.
The two other options to decide on if the school decides to
purchase eight minibuses are (1) retaining the full-size buses for future
purposes, and (2) selling them.
3. Prepare a net-present value analysis of the two options for the
five full-size buses.
If the school decides to sell its buses, the proceeds will be equal
to $75,000. This is computed by multiplying the number of buses to be
sold (5 buses) with the estimated selling price ($15,000 each).

If the school decides to reserve the buses, the present value of


the savings will be equal to $90,120. The computation is presented on
the next page.
Annual savings on bus charter fees ($30,000 - $5,000)
$ 25,000
PV of ordinary annuity for 5 years at 12%

3.6048
Present value of savings

90,120
Since the present value of the savings is greater than the
proceeds from selling the buses, the school must reserve the buses
instead of selling them. It must be noted that the proceeds if the buses
are sold today is not discounted because it is already at its present
value.
4. Prepare

net-present

value

analysis

of

the

two

main

alternatives, taking into account the decision derived from


item 3.
The computation necessary if the minibuses are to be purchased
is presented below. There is no need to prepare a NPV analysis for the
full-size buses because that alternative is the one currently in use.
Additional wages to be paid if minibuses will be purchased
($18,000 x 3)
54,000.00)
Savings from maintenance costs [($50,000 x 5) ($20,000 x 8)]
90,000.00
Annual savings on bus charter fees
25,000.00
Annual savings (or annual cash inflows)
$

61,000.00

($

PV of ordinary annuity for 5 years at 12%

3.6048
Present value of Savings

219,892.80
Less: Acquisition costs ($27,000 x 8)
216,000.00
Other costs
15,250.00
Net-present value

($

11,357.20)
Since the NPV of purchasing eight minibuses is lower than zero,
the school should just remain using its five full-size buses.
5. Compute for the internal rate of return on the proposed
minibus acquisition.
The formula used for computing the internal rate of return is:
Initial cash outflows
PV Factor = ------------------------------Annual cash inflows
The resulting PV Factor is equal to the internal rate of return for
the specified number of periods (in this case, 5).
The computation for the initial cash outflows is presented below.
Acquisition costs ($270,000 x 8)

216,000.00
Other costs
15,250.00
Initial cash outflows
231,250.00

On the other hand, the computation for the annual cash inflows
can be referred from item 4.
Following the formula, the PV Factor is equal to 3.7910. The
computation is presented below:
$ 231,250
PV Factor = ----------------- = 3.7910
$ 61,000
Looking at a table of present value factors, 3.7910 is equal to the
present value factor of ordinary annuity for 5 periods at 10%. Thus, the
internal rate of return of the project is 10%.
6. Identify which information in the case is irrelevant. Explain the
reason behind the claim.
It can be observed that out of all the data given in the case, only
the acquisition cost of a full-size bus is not used. This is so because
depreciation of assets is not included in the computation of net-present
value and internal rate of returns since it does not involve a flow of
cash. The two methods specifically require a flow of cash, or at least
savings in cash. On the other hand, the useful lives of the full-size
and minibuses have been used in the discussion. Since the remaining
useful life of the full-size buses is equal to 5 years, the computation for
the savings

from

charter

fees

is derived from a

year

perspective. Furthermore, the annual savings from the purchase of


minibuses is at 5 years because the useful life of the minibuses is
assumed to be at that span of time.
Thus, the only irrelevant data from the case is the acquisition
cost of the full-size bus.
IV. OTHER DISCUSSIONS

The case also talked about an ethics issue. The situation follows
George Lynagh, the business manager of the Warringah Central School
meeting long-time friend David Windon who is the vice president of the
private company the minibuses will have been purchased from. Lynagh is
just about to propose the decision of retaining the full-size buses instead of
purchasing minibuses. Learning of the proposed verdict, Windon persuades
Lynagh, who is said to be poorly paid, to work in his company under the
condition that the latter rethink his decision for the school. It is then asked
what Lynagh should do regarding the matter and discuss the ethical issues in
it.
In the perspective of Lynagh, Windons offer may be more helpful for
him financially. But being an employee of the school, Lynagh must choose
otherwise. Quoting a teacher, one must not pollute the river he is getting
clean water from. Lynagh must be faithful to the entity he is working for,
especially since he is working for a school which is in the service of students.
Furthermore, Windon is proposing that job offer not because they are friends
but because he has interests that can impair the correct decisions of a
learning institution. Who knows, Lynagh may actually get a better pay if the
school learns of his faithfulness.