Problem 4

John Doe currently leases a full size pickup truck. The three year lease is set to expire and John is considering whether to lease a similar truck or to be more practical and to lease a 5 passenger car as he has a growing family (his wife currently drives a minivan and they must her vehicle for most trips). Furthermore, the truck he currently drives only averages about 16 miles per gallon. Fuel prices have been rising steadily and now hover around $4.05 per gallon. The oil futures market does not appear to indicate any relief in the price of oil over the next five years. The current lease on the truck limits mileage to 36,000 miles with mileage costing $0.20 for every mile over this threshold. Over the past three years, John has driven the truck 13,150 miles, 11,511 miles, and 12,705 miles, respectively. Johns overall driving patterns are not expected to change over the coming three years, so the average annual mileage he has driven over the past three years will likely hold for the next three years.

To lease a similar truck, with $2,000 down, will cost John $300 per month. A similar truck will also have a $0.25 per mile charge for any mileage incurred over 36,000 miles. Insurance for the truck will be approximately $275 every six months. Annual license and registration, since he can register it as a farm vehicle, is low at $175 per year. This truck is expected to do slightly better on fuel mileage and should average 18 miles per gallon, based upon its EPA fuel rating for combined city and highway driving. Since the truck will be leased for a 3 year window, no maintenance expenses are expected other than oil changes. The cost to change the oil for this truck, due to the large engine size, is typically around $75 per oil change. John typically changes the oil after every 5,000 miles of driving

To lease a car will require a $1,500 down payment and the monthly lease amount will $350. The car will have a $0.175 overage charge for any miles driven over 33,000 at the end of the three year lease. Insurance on the car will be $400 every six months. Annual license and registration will be $500. The cars EPA fuel rating is 30 miles per gallon for combined city and highway driving. The expected cost of an oil change is $45.

If John does purchase the car, one factor he must consider is the lack of hauling capacity. John estimates that 5 times per year he utilizes the bed in his truck for hauling various items. The mileage on these trips usually total about 100 miles, round trip, for each. If John purchased the car, he would need to rent a truck perform those tasks. The cost to rent a similar truck for a day is approximately $100 per day, according to a local rental companys website.

A. For each of the two alternatives, calculate the total undiscounted 3-year cost of each decision. Focus only on relevant costs and compute the overall cost differential between the two decisions. From a purely financial standpoint, which alternative appears best?

B. What qualitative factors should John also build into this decision? From a quantitative standpoint, what technique could we employ to make this analysis better?

C. What sources of risk or variation are present in this analysis? How might John assess these and even potentially manage them?