Question

Assume that Wal-Mart Stores, Inc. has decided to surface and maintain for 10 years a vacant lot next to one of its stores to serve as a parking lot for customers. Management is considering the following bids involving two different qualities of surfacing for a parking area of 12,000 square yards.

Bid A: A surface that costs \(5.75 per square yard to install. This surface will have to be replaced at the end of 5 years. The annual maintenance cost on this surface is estimated at 25 cents per square yard for each year except the last year of its service. The replacement surface will be similar to the initial surface.

Bid B: A surface that costs \)10.50 per square yard to install. This surface has a probable useful life of 10 years and will require annual maintenance in each year except the last year, at an estimated cost of 9 cents per square yard.

Instructions Prepare computations showing which bid should be accepted by Wal-Mart. You may assume that the cost of capital is 9%, that the annual maintenance expenditures are incurred at the end of each year, and that prices are not expected to change during the next 10 years.

Short answer

Wal-mart should accept bid A.

Step-by-step solution

Computation for the bid A

$$\begin{gathered} \mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{outflows}\mathbf{=}\mathbf{Initial}\mathbf{}\mathbf{Surface}\mathbf{+}\mathbf{Present}\mathbf{}\mathbf{value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{annual}\mathbf{}\mathbf{maintenance}\mathbf{}\mathbf{cost}\mathbf{+}\mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{replacement}\mathbf{}\mathbf{Surface} \\ \mathbf{=}\mathbf{69}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{3}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{5}\mathbf{.}\mathbf{99525}\mathbf{+}\mathbf{69}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{64993} \\ \mathbf{=}\mathbf{69}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{17985}\mathbf{.}\mathbf{75}\mathbf{+}\mathbf{44845}\mathbf{.}\mathbf{17} \\ \mathbf{=}\mathbf{\$}\mathbf{131}\mathbf{,}\mathbf{830}\mathbf{.}\mathbf{92} \end{gathered}$$

Computation for the bid B

$$\begin{gathered} \mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{outflows}\mathbf{=}\mathbf{Initial}\mathbf{}\mathbf{Surface}\mathbf{+}\mathbf{Present}\mathbf{}\mathbf{value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{annual}\mathbf{}\mathbf{maintenance}\mathbf{}\mathbf{cost} \\ \mathbf{=}\mathbf{126}\mathbf{,}\mathbf{000}\mathbf{+}(\mathbf{1}\mathbf{,}\mathbf{080}\mathbf{\times }\mathbf{5}\mathbf{.}\mathbf{99525}) \\ \mathbf{=}\mathbf{126}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{6}\mathbf{,}\mathbf{474}\mathbf{.}\mathbf{87} \\ \mathbf{=}\mathbf{\$}\mathbf{132}\mathbf{,}\mathbf{474}\mathbf{.}\mathbf{87} \end{gathered}$$

Wal-mart stores should Accept bid A.