Suppose you have the opportunity to acquire a taxi license that gives you the right to operate a taxi cab. The following information on the ?xed costs of operating a cab for a year are shown in Table 1. You expect that your cab will provide 2500 rides in a year at an average fare of $15.00 and average fuel usage of $5.00. You can buy a car that is just acceptable for $20,000, but it will only last for two years and then its salvage value will be essentially zero. The cost of the cab is sunk. Your brother-in-law, the accountant, informs you that it would be normal to depreciate the cab using straight line depreciation or $10,000 per year. He calculates that this means a rate of return in the ?rst year of 20% and since the return on your next best alternative is 22% suggests that you not invest in the taxi license.
(a) What is the internal rate of return on this investment? Assume that the cab is paid for at the beginning of the ?rst year, but that the annual cash ?ows happen at the end of the year.
Commercial Insurance $2,000.00/year
Taxi License $1,000.00/year
Wages for Driver $8,000/year
Table 1: Cost of Operation
(b) Would you agree with your brother in law that it is a bad investment? Why?
(c) What is depreciation?
(d) What is the exact deprecation for year 1? For year 2? What is the advantage of using exact depreciation?