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CASE 1

The board of education for the Warringah Central School is considering the
acquisition of several minibuses for use in transporting students to school. Five
other school districts bus routes are underpopulated, with the result that the full
size buses on those routes are not fully utilized. After a careful study, the board has
decided that it is not feasible to consolidate these routes into fewer routes served
by full-size buses. The area which the students live is too large for that approach,
since some students bus ride to school would exceed the state maximum of 45
minutes.
The plan under consideration by the board is to replace the five full-size
buses with eight minibuses, each of which would cover a much shorter rote than a
full-size bus. The bus drivers in his rural school district are part-time employees
whose compensation costs the school district $18,000 per year for each driver. In
addition to the drivers compensation, the annual costs of operating and
maintaining a full-size bus amount to $50,000. In contrast, the board projects that a
minibus will cost only $20,000 annually to operate and maintain. A minibus driver
earns the same wage as a full-size bus driver. The school district controller has
estimated that it will cost the district $15,250, initially, to redesign its bus routes,
inform the public, install caution signs in certain hazardous locations, and retrain
drivers.
A minibus costs $27,000, whereas a full-size bus costs $90,000. The school
districts uses straight line depreciation for all of its long-lived assets. The board has
two options regarding the five full-size buses. First, the buses could be sold now for
$15,000 each. Second, the buses could be kept in reserve for use in field trips and
out-of-town athletic events and to use as backup vehicles when buses breakdown.
Currently, the board charters buses from private company for these purposes. The
annual costs of chartering buses amounts to $30,000. The school district controller
has estimated that this could be cut to $5,000 per year if the five buses were kept
in reserve. The full-size buses have five years of useful remaining, either as a
regularly scheduled buses or reserved buses. The useful life a new minibus is
projected to be five years also.
Warringah Central School uses a hurdle rate of 12 percent on all capital
projects.

1. Think about the decision problem faced by the board of education. What are the
boards two main alternatives?
2. One of these two alternatives has two options embedded into it. What are those
two options?
The diagram shows the alternatives the board may have in their decision making

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MAIN
ALTERNATIVES
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What to do with the full-size

SECONDARY
ALTERNATIVES

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The board may either continue to use full-size buses on regular route or
purchase these buses with 8 mini buses. Under purchase, the board will
think of what will they do to the full-size buses, these buses can be sold
for $15000 each or they could make it as a reserve for fieldtrips or as a
backup
for
buses
breakdown.

3. Before proceeding check the hint given at the end of the chapter, which explains
and diagrams the school boards alternatives. Suppose the board of education
chooses to buy the minibuses. Prepare a net-present-value analysis of the two
options for the full-size buses. Should these buses be sold now or kept in
reserve?
If it is sold now,
Selling price ($ 15 000 x 5)
PV of $30 000
Total Costs

$ 75 000
(108 143. 29)
$ 33 143. 29

If kept for reserved,

PV of $ 5000@ 12 =$ 18 023 .88

The company will have a lesser cost if they will keep the buses on reserve.
4. From your answer to requirement (3), you know the best option for the board to
choose regarding the full-size buses if the minibuses are purchased. Now you
can ignore the other option. Prepare a net-present-value analysis of the school
boards two main alternatives: (a) continue to use the full-size buses on regular
routes or (b) purchase the minibuses. Should the minibuses be purchased?
a.) Keep using the full size bus
PV of total cash flows
Annual compensation of drivers ($18 000 x 5)
Annual operation and maintenance costs ($50 000 x 5)
Total
Present value factor 12%
Present value of costs

90 000
250 000
$
340 000
x
3.6
$ 1 225 623.
91

b.) Purchase the minibus


Selling costs of full-size buses ($ 15 000 x 5)
Acquisition cost of minibuses ($27 000 x 8)
Initial cost to incur

Annual Compensation of drivers ($18 000 x 8)


Annual operation and maintenance costs ($20
000 x 8)
Total
Present value factor 12%

($ 144 000)
(160 000)

Total Costs

75 000
(216 000)
(15 250)

($ 304 000)
x
3.6

($

156 250)

(
1 095 852.
97)
($ 1 252 101.
97)

Keeping the full size buses is more favourable by $ 26 478. 06 than


purchasing new minibuses
5. Compute the internal rate of return on the proposed minibus acquisition.
Present value of incremental annual cash flows
Present Value factor 12%
Annual cash flows
Cash outflow
Annual cash flow
Internal rate of return factor

$ 129 780
3.6
$ 36 000
156 250
36 000
4.34

This 4.34 factor is under the 4.91%, and since it is less than the hurdles
rate of the school which is 12%, acquisition of minibuses should be
rejected.

6. What information given in this case was irrelevant to the school boards decision
problem? Explain why the information was irrelevant.
Among the given information, the cost of full size buses and the
method of depreciation are irrelevant, depreciation expense may be
computed if the life of the asset is given. In any way, depreciation will
not affect the cash flow; it is added back to profit when getting the
cash flows from operating activities.
7. Independent of requirements (1) through (6), suppose the NPV analysis favors
keeping the full-size buses. George Lynagh, business manager for the Warringah
Central School, was prepared to recommend that the board not purchase
minibuses. Before doing so, however, Lynagh ran into a long-time friend at the
racquet club. David Windon was the vice president for sales at a local
automobile dealership from which minibuses would have been purchased. The
two talked for some time about the pros and cons of minibus alternative. Finally,
Windon said, George, you and I have been mates for a long time. I know youre
not paid all that well at school district. Our top financial person is retiring next
year. How would you like to come to work for the dealership?
Thats pretty tempting, David. Let me think it over, was Lynaghs response.
Sure, George, take all the time you want. In the meantime, how about
rethinking that minibus decision? Its no big deal to you, and I could sure use
the business.
But David, I told you what the figures say about that, responded Lynagh.
Come one, George. What are friends for?
Discuss the ethical issues in this situation. What should George Lynagh do?
George Lynagh should always act in integrity, being the business manager
of the school, the board will likely to believe that what he is saying true. If
the analysis favors keeping full-size buses, then he should tell the board
the truth otherwise he is acting for his own benefit, and not of the school.