EXAMPLE 6.7 Ramu, a salesman, needs a new car for use in his business. He expects that he will be promoted to a supervisory job at the end of third year and so his concern now is to have a car for the three years he expects to be "on the road". The company will reimburse their salesman each month the fuel cost and maintenance cost. Ramu has decided to drive a low-priced automobile. He finds, however, that there are two different ways of obtaining the automobile. In either case, the fuel cost and maintenance cost are borne by the company. (a) Purchase for cash at Rs. 3,90,000. (b) Lease a car. The monthly charge is Rs. 10,500 on a 36-month lease payable at the end of each month. At the end of the three-year period, the car is returned to the leasing company. Ramu believes that he should use a 12% interest rate compounded monthly in determining which alternative to select. If the car could be sold for Rs. 1,20,000 at the end of the third year, which option should he use to obtain it? Alternative 1-Purchase car for cash Purchase price of the car = Rs. 3,90,000 Life = 3 years = 36 months Salvage value after 3 years = Rs. 1,20,000 80 Engineering Economics Interest rate= 12% (nominal rate, compounded annually) = 1% compounded monthly The cash flow diagram for alternative 1 is shown in Fig. 6.15. 1.20.000 0 1 2 3 36 3,90,000 Fig. 6.15 Cash flow diagram for alternative 1. The monthly equivalent cost expression [ME(1%)] of the above cash flow diagram is ME(1%) = 3,90,000(A/P, 1%, 36) - 1.20,000(A/F, 1%, 36) = 3,90,000(0.0332) - 1.20,000(0.0232) = Rs. 10,164 Alternative 2-Use of car under lease Monthly lease amount for 36 months = Rs. 10,500 The cash flow diagram for alternative 2 is illustrated in Fig. 6.16. 0 1 2 3 36 10,500 10,500 10,500 10,500 Fig. 6.16 Cash flow diagram for alternative 2. Monthly equivalent cost = Rs.10,500. The monthly equivalent cost of alternative 1 is less than that of alternative 2. Hence, the salesman should purchase the car for cash. EXAMPLE 6.8 A company must decide whether to buy machine A or machine B. Machine A Machine B Initial cost (Rs.) 3,00,000 Useful life (years) 4 Salvage value at the end of machine life (Rs.) 2,00,000 Annual maintenance (Rs.) 30,000 6,00,000 4 3,00,000 0 At 15% interest rate, which machine should be purchased