Payback Period and NPV of a Cost Reduction ProposalDifferential Analysis

Hermione decided to purchase a new automobile. Being concerned about environmental issues, she is

leaning toward the hybrid rather than the gasoline only model. Nevertheless, as a new business school

graduate, she wants to determine if there is an economic justification for purchasing the hybrid, which

costs $1,595 more than the regular model. She has determined that city/highway combined gas mile-

age of the hybrid and regular models are 30 and 24 miles per gallon respectively. Hermione anticipates

she will travel an average of 12,000 miles per year for the next several years.

Required

a. Determine the payback period of the incremental investment if gasoline costs $2.75 per gallon.

b. Assuming that Hermione plans to keep the car about six years and does not believe there will be a

trade-in premium associated with the hybrid model, determine the net present value of the incre-

mental investment at six percent time value of money.

c. Determine the cost of gasoline required for a payback period of three years.

d. At $4.60 per gallon, determine the gas mileage required for a payback period of three years.