Steve is a contract carrier for the United States Postal Service. He has been hauling mail for nearly thirty years. His current contract is to haul mail between 20 cities in the eleven western states. Steve currently has a fleet of 16 tractors and employs over 20 drivers. He does not own any trailers as all of the trailers are owned by the Postal Service. Steve’s drivers drive scheduled routes between the cities.
The Postal Service has just awarded Steve an additional contract that will require Steve to purchase six new tractors. He competed aggressively for the contract and spent a total of $45,000 in costs to prepare and submit the bid. Steve has narrowed his decision of which truck to buy down to two choices. He can purchase Mack tractors or Freightliner tractors. The Mack tractors would cost $255,000 each where the Freightliners would only cost $220,000 each. Both models would be depreciated to zero over 5 years using straight line depreciation.
The Postal Service contract pays Steve $2.85 per mile and the new contract routes call for the each new tractor to be driven 100,000 miles per year. Costs associated with each new tractor include wages for the drivers at $75,000 per truck per year and regular service and maintenance at a cost of $1,500 per month per truck. Fuel costs vary as Mack is more fuel efficient than the Freightliner. Assume the tractors will be driven 100,000 miles per year and diesel costs will average about $3.25 per gallon. The Mack is expected to get 3.4 miles per gallon while the Freightliner will get 3.2 miles per gallon. Insurance and licensing is expected to cost $6,000 per truck per year and is the same for both trucks.
Both models will require a complete engine overhaul at 300,000 miles and Steve estimates that this will be during the third year of ownership. The cost of an overhaul on the Mack is estimated at $38,000 per truck while the cost on the Freightliner is estimated at $45,000 per truck. All other maintenance costs are believed to be the same for each tractor.
Steve expects to keep the trucks for six years after which time he will sell them. He will not overhaul the tractors in year 6 as it will not increase their value. He predicts that he will be able to sell the Mack’s for $60,000 each, but the Freightliners will be worth only $50,000 each. Steve’s cost of capital is 14%. The company is in the 34% tax bracket.
When Steve got started in the business his first truck was a Mack. While they cost more Steve believes that they are a better truck and he love’s the sleek and powerful look of a Mack. Because of this he is leaning towards buying the Mack tractors. But after hearing that you have learned about capital budgeting in your Finance class at UVU he wants to take advantage of your expertise. Steve has asked you to analyze his choices and give him some advice on what he should do.
1. Determine which tractor you would recommend that Steve purchase.