You and your friend are avid snowboarders and bike racers. Nearly every other weekend you travel to a race in a rented van. Now that both of you have full-time jobs, your friend is pressuring you to purchase a van.
Here’s how the conversation goes:
Friend: “just think of how much we will save on rentals. The rented van costs us $ 100 a weekend, plus $.50 per kilometre. Most trips are 100 kilometres, one way. With our own van, we will only have to pay for fuel about $.08 per kilometre-and maintenance, about $.25 per kilometre. A used van will only cost about $20,000. Think of the convenience!”
You: “What about insurance? What about depreciation?”
Friend: “Insurance will be only $ 1,200 per year. The salesperson says the van will depreciate slowly, only 10% per year. If we retire from the race circuit in 5 years, the van will still have value. Shouldn’t we at least think about it?”
You: “I guess. I think a nominal discount rate of 9% is about right.”
a. Do you think you should buy the van? Be sure to state your assumptions.
b. What if all costs are subject to a 3% annual inflation? Do you change your mind?