Heavy Equipment Options

SITUATION:

The New Orleans District of the U.S. Army Corps of Engineers, within the last year, received a request by the Louisiana Department of Public Works for environmental control assistance in an important residential area. This area is a residential suburb of the city ofHammond, and it has been subject to frequent and severe flooding for many years. The feasibility study conducted by the New Orleans District concluded that means for reducing the flooding exist, and a subsequent study recommended the course of action outlined below. You are the Chief Financial Officer (CFO) of Worldwide Construction., Inc., and your firm has been awarded the contract for procuring and delivering fill materials during the construction and initial maintenance phases of the project. Because of extensive commitments elsewhere in theUnited States, your firm does not currently have enough heavy equipment to complete the task. Your assignment is to determine the most economical means for the company to fulfill its obligations.

The residential areas of concern are located in the upper part of a watershed about five miles west of the city ofHammond. Eighty-seven homes have been subjected to repeated flooding, and total average annual damages in this area have been estimated at $842,150. Floods occurred in the area during the last six years, causing widespread damage.

To address these flood problems, the engineer design team developed several alternative plans. The plan that was eventually selected involves the construction of a long bypass channel around the affected residential areas. This channel will begin at the roadway upstream of the area and will travel through an undeveloped area in an easterly direction. A levee on the southern side will divert runoff into the new channel. This diversion channel will require several drop structures in order to control the speed of runoff through the channel and will be lined with grass between those structures. Two new bridges will be required for the channel, as will the removal of at least five houses in the area. Savings from damage control will be realized beginning in 1994.

Although the channel excavation will provide much of the material required for levee construction, the soil aroundHammondis too sandy for exclusive use. Your contract calls for you to procure and deliver additional soil with a higher clay content. Specifically, your firm is to deliver 320,000 cubic yards per year both this year and next, and then 185,000 cubic yards per year for the following six years. You have already purchased the rights to the required amount of material (to be extracted from a pit already in operation in another part of the state), and you have subcontracted the equipment required to excavate and load the material. Your sole remaining task is to identify how to transport the material to the construction site.

TRANSPORT OPTIONS:

You have narrowed your vehicle choice to the Mark Transporter and the Kenwood Hauler, and you are considering both leases and outright purchases of each vehicle.

Mark Transporter T-5

Capacity: 5 cubic yards

Current purchase price: $51,050

Two-year lease option: $1350 per month; last month's lease due at delivery; purchase option at the end of lease for projected fair market retail value of $36,500 (current dollars). Sum of total monthly payments for two-year lease=$32,400. Lessee responsible for all maintenance and upkeep costs.

Estimated operation and maintenance costs: $2300 per year for the first three years; increasing by $300 per year every year thereafter.

Kenwood Hauler H-85

Capacity 8.5 cubic yards

Current purchase price: $73,400

Two-year lease option: $1700 per month; last month's lease due at delivery; purchase option at the end of the lease for projected fair market value of $55,000 (current dollars). Sum of total monthly payments for two-year lease =$40,800. Lessee responsible for all maintenance and upkeep costs.

Estimated Operation and Maintenance Costs: $3000 for the first year; increasing by a real rate of 10% per year every year thereafter.

Purchase/Lease Options:

The prices that you have been quoted are dependent on using each truck exclusively, and you have already considered and eliminated the possibility of combining smaller numbers of the different trucks. Regardless of the truck that you choose, the following three purchase/lease options exist:

Option 1: Purchase all the trucks required for the initial two-year period, sell the trucks not required for the last six years as soon as they are no longer needed, and sell the rest of the trucks when the contract expires.

Option 2: Lease all the trucks required for the initial two-year period, invoke the purchase option at the end of the two years for enough trucks to fulfill your remaining obligations, and sell the trucks that you purchased when the contract expires.

Option 3: Purchase (now) all the trucks that you will need for the last six years of the project, and sell them at the end of the eight year period. Lease any additional trucks that you will need for the first two years.

CONDITIONS:

All cost figures, unless obvious from the context or otherwise identified are in constant 1991 dollars. Contractual agreements, such as leases, are expressed in current dollars unless they specifically contain inflation-linked escalation clauses. The anticipated general inflation rate over the next 10 years is 4.5% per year.

A 7.5% real annual interest rate is used by your firm for discounted cash flow calculations.

The distance between sites and the loading capacity of your excavation equipment will limit each truck to, on average, six round trips per day of operation.

You may estimate the fair market retail value for trucks that are older than two years old by applying a real rate of decline of 10% per year to the fair market retail value of two-year-old trucks. You expect to pay the full retail value of you are purchasing trucks, but expect to receive only 80% of that amount if you are selling trucks.

The Chief Executive Officer (CEO) has indicated a strong desire to continue the firm's past relationship with the manufacturer of the Mark Transporter, but he has also committed to a series of cost-cutting moves within the company that suggest to you that he finds the economic consequences of decisions to be the most important at the current time. You also know that he believes that cost differences of 5% or less, given the natural uncertainty of the many estimates that are required in evaluations such as the one that you are conducting, are usually not sufficient to override significant non-monetary concerns.

You maynotapproximate your annual lease payments by simply summing your monthly payments. The requirement to pay your last month's lease at time of delivery does not reduce your total number of lease payments, but does shift the timing of them.

If you choose, at any point, to purchase vehicles, you will pay for them with cash from corporate funds.

REQUIREMENT:

Please explain how a step by step economic analysis of this scenario can be conducted. I am looking to understand and learn