Managerial Decisions in Economic Terms - Research Paper Example

 Managerial Decisions in Economic Terms Executive Summary The purpose of the project is to select the best alternative between purchasing and leasing a car. It is a critical and an important decision to be taken by the manager of the organisation. The primary task is to analyze the purpose of the project and the solution that it aims to find. Both alternatives involve their respective costs, which have been discussed at length. Both cases have their own set of pros and cons. This has been explained under the head ‘Factors or Costs’. It is seen that a number of variables come into play while deciding between two alternatives. The project makes suitable assumptions, like, the present value of discounting, the number of miles that car intends to run and the charge involved in travelling the extra miles over and above the stipulated miles allowed in the lease contract. Finally, a comparison is made between the present values of the two alternatives. It discusses three situations. It finds the present value of the car purchase, present value of the car purchase using a loan and the present value of the lease along with purchasing option. The project seeks to find the best and the most cost effective alternative from the above three cases. Table of Contents Managerial Decisions in Economic Terms 1 Executive Summary 1 Table of Contents 2 Introduction 3 Definition 3 Factors or Costs 4 Measurement 5 Analysis 6 Conclusion 8 References 9 Bibliography 10 Introduction This project tries to find out the basis of applying managerial decisions under different circumstances. In this case, decision has to be taken between the two alternatives of buying a car or leasing it. The best possible way is to compare the costs involved in both cases. The aim of the project is to find out the most cost effective method of transaction by calculating the present value of the discounted cash flow. Firstly, it discusses the advantages and disadvantages of leasing and owning a car and the costs involved in both cases. This project aims to help managers in making decisions between a lease and a purchase. An analysis is conducted under three given situations before a conclusion is drawn. It is not a simple method and involves a host of other factors like the number of miles that the buyer intends to travel, and the rates of interest prevailing at that time. Definition The managerial decision of whether to lease or buy a car is of primary concern in this project. The project will act as the mouthpiece for a public school system which is to decide whether it would economical to lease a car or to buy it. Both have got their respective benefits and costs. The motive of the project is to detect which would be the most cost effective method. In order to come to a final decision, a comparison of costs needs to be done which will take into account the depreciation value of each car, the period of time for which the car can be used, down payments or capitalized reduction in costs. In brief, both financial as well as non financial evaluations are required to resolve the problem. Factors or Costs Factors and costs take into account the possible advantages and disadvantages of buying or leasing a car. There are certain advantages of leasing a car. The lease payments required on a monthly basis are lower than that required for buying a car. In this case, since the car would be used is a public school, a lease agreement would have provisions for maintaining a detailed record for the purpose of tax. Further, it does not require putting down huge cash amounts at the beginning of the lease. However, there are certain disadvantages also. The process of lease payments on a monthly basis is a never ending one. It would really be a pity to buy the car after the lease, because this would mean paying more for the car than if it had been bought originally. Further, a termination fee is charged on turning in the car early (Faerber, 2003, p. 135). Taking the above stated reasons into account, it seems that buying a car would be the most cost effective. Another disadvantage of leasing is that it has to give a certain amount of mileage allowance. It is assumed that the car runs 10,000 to 15,000 miles each year. There is no credit involved if a lesser amount of mileage is used. However, it involves a certain penalty if the car is run more than the stipulated mileage. If it is known that the extra mileage will be more than that of the allowance, then it is advisable to buy additional miles, but this can be an expensive issue. This can be explained with an example. Let the contract read 10,000 miles/year for a lease of 36 months and for each extra mile an amount of 20 cents per mile is charged. The actual mileage comes to 20,000. The charge for these extra miles comes to $6,000 (30,000 * 20€). Since, this is quite a big amount, it is advised that if the car has to travel extra miles it is a better option to buy the car than lease it (Little, et al. 2003, p.101). Measurement In this section a lease example is provided. It is assumed that the cost of the car is $20,000. Again, it is assumed that buyers are completely aware of the buying options. In the long run, buying outright would generally cost less than leasing. It is to be noted how the car value is determined during signing of the lease, if the car has travelled very long distances. It is assumed that the driving mileage as limited by the lease is 15000 miles. After this limit, a certain amount is charged per mile of overuse. If the car is terminated at an earlier stage, then a penalty cost is charged. It is assumed that the leasing company charges a financing rate which is equal to the amount charged by a bank in case of purchase transactions. Since the leasing company has to pay a much lesser amount in comparison to a financial institution, they are able to earn profit through that difference. But there is more to this. Every lease is valued at a much lower level than its true value. Thus, a residual value is left after the expiry of the lease. The residual value can then be used for other investment purposes. In this case, let the residual value be $4,000. For leasing it, the buyer has to pay $430 per month for 48 months. Alternatively, the buyer can invest the money at a minimum of 5% rate of return. This would amount to $25,000 over a period of 4 years. Thus it is seen that buying is always a better option than leasing (Pooler & Pooler, 1997, p.262). Nowadays, leasing has gained much popularity over private ownership of cars. A comparison is therefore required between the costs of ownership and lease payments. Usually, the terms of lease runs from three to five years along with payments on a monthly basis. This section tries to evaluate the difference between purchase contracts and lease contracts by the method of discounting (Soderlind, 2001, p.273). Both the methods of purchasing and leasing have their respective streams of costs involved for any given automobile. The basic difference between the two is that leasing does not involve equity while the process of purchasing does. After a few years it is seen that the person who had bought the car has gained an equity which can be recovered by reselling the car. This is not possible in case of lease. However, in case of both owning and leasing the car, payments have to be made for licensing, insurance, title, etc. The primary reason behind leasing is to avoid principle payments and ownerships. But certain lease agreements give the lessee the additional option to purchase the car or vehicle after the expiry of the lease period at a price which is pre-arranged. There are two basic ways of assessing the better deal. The first method of evaluation assumes that the lessee decides to buy the car at the end of the lease period. The second method assumes that the person buying the car decides to sell it at the end of four years. Finally, a comparison is made between the two alternatives. Analysis This section provides a comparative analysis between the two situations. Figure 1: Evaluating Lease and Purchase Options by using Present Values (Source: Soderlind, 2001, p.274) It is assumed that the person who is thinking of owning the car is of the opinion that buying with cash would be the best deal. A number of corrections are required to get the perfect and precise picture of the comparison made between purchasing and leasing. Leases involve a small amount of ‘damage deposit’. The potential interest earned on this deposit is ignored. The above table shows that the best option at any given situation actually depends on the rate of interest and terms of the loan, rate of discounting dollars, terms in the lease contract and the presence of any rebates given to the buyers. The best possible method to analyze the two situations is by discounting. Using the present values of discounting which is 10%, the lease cost amounts to $9856. If the lessee decides to purchase the car at the end of the lease period, the present value will come to $3415. Present value of the loan payments and present value of down payments amounts to $11,829 and $1000 respectively. In case of purchasing the car by cash, its present value amounts to $12,000. Thus, present value of the lease along with the option to purchase amounts to $13,272. If the purchase is done using a loan, its present value is $12,829. In case of direct purchase using cash, the present value is $12,000. Thus, the least amount of cost involved is in the cash purchase. An important issue lies in the actual market value of the car comes at the end of four years when its lease expires. If it is seen that the resale value exceeds the “purchase option price on a lease” (Soderlind, 2001, p.274), then purchasing would be a better option than leasing. However, it is not possible to estimate the future value of market when the purchase is done. This is why a certain amount of gambling is always involved on the part of the owner or buyer of the car. To sum it all, the decision whether to lease or to purchase is basically a financial one. The choice of the better option depends on the rates of interest, market value of the car in the future and the lease charges (Soderlind, 2001, p.275). Conclusion Thus it can be concluded that the best decision is to purchase the car. However, this is not true for all situations. A host of other factors are involved while making a purchase or taking a lease decision. The most appropriate way of calculating is by discounting the present value of car under different situations. Among the three situations, wherein the first case the buyer decides to sell the car after four years, in the second case the lessee decides to buy the car after the expiry of the lease, and in the third case the person concerned decides to cash purchase the car, the last alternative seems to be the most suitable one. Further, the act of buying the car also involves an additional advantage of gaining equity which is recoverable by reselling the car. In case of leasing the car, no such advantage is involved. Lastly, it is recommended that if the car has to travel very long distances, then the better option would be to buy the car because the cost charged for travelling the extra miles is generally very high. References Faerber, E. (2003). The Personal Finance Calculator: How to Calculate the Most Important Financial Decisions in Your Life. McGraw-Hill Professional. Little, K.E., DeSalvo, D., Koch, E. T. (2003). The Complete Idiot's Guide to Savvy Investing. Alpha Books. Pooler, D. J. & Pooler, V. H. (1997). Purchasing and supply management: creating the vision. Springer. Soderlind, S. (2001). Consumer Economics: A Practical Overview. M.E. Sharpe. Bibliography Lehman, D & Png, I. (2007). Managerial economics. Wiley-Blackwell. Png, I. (2002). Managerial economics. Wiley-Blackwell. Read More