The Department of National Defence has the difficult decision of deciding which military bases to close down. Military and political factors obviously matter, but cost savings are also an important factor. Consider two naval bases one in Vancouver, British Columbia, and one in Halifax, Nova Scotia. National Defence has decided that it needs only one of those two bases permanently, so one must be shut down. The decision regarding which base to shut down will be made on cost considerations alone. The following information is available:
a. The Vancouver base was built at a cost of $100 million. The operating costs of the base are $400 million per year. The base is built on land owned by National Defence, so it pays nothing for the use of the property. If the base is closed, the land will be sold to developers for $500 million.
b. The Halifax base was built at a cost of $150 million on land leased by National Defence from private citizens. National Defence can choose to lease the land permanently for an annual lease payment of $3 million per year. If it decides to keep the Halifax base open, National Defence plans to invest $60 million in a fixed income note, which at 5% interest will earn the $3 million the government needs for the lease payments. The land and buildings will immediately revert to the owner if the base is closed. The operating costs of the base, excluding lease payments, are $300 million per year.
c. If the Vancouver base is closed down, National Defence will have to transfer some personnel to the Halifax facility. As a result, the yearly operating costs at Halifax will increase by $100 million per year. If the Halifax facility is closed down, no extra costs will be incurred to operate the Vancouver facility.
REQUIRED
The British Columbia delegation argues that it is cheaper to close down the Halifax base, for two reasons:
(1) It would save $100 million per year in additional costs required to operate the Halifax base, and
(2) It would save $3 million per year in lease payments. (Recall that the Vancouver base requires no cash payments for use of the land because the land is owned by National Defence.) Do you agree with the British Columbia delegation’s arguments and conclusions? In your answer, identify and explain all costs that you consider relevant and all costs that you consider irrelevant for the base-closing decision.