Are High(er) MPG Cars Worth the Money?
The Consumerist headlined a post the other day It Could Take Years For Some FuelEfficient Cars To Be Worth The Savings On Gas. The title was enough to annoy me.
It seems that some car makers produce higher MPG versions of their already fairly fuelefficient offerings. And, of course, these special versions are a bit more expensive. Assuming that all a consumer is interested in is money (and not greenness) the question is whether or not that additional cost is justified by the savings on gas.
And there is an accepted and well justified right way to answer that question and others like it. Basically, and I will get to details in a moment, you consider the extra cost as a potential investment with a projected return and compare that to other investments you might otherwise make with the money.
One of the wrong ways to answer the question is the approach taken by The Consumerist and the Consumer Reports item it summarizes, the number of years it would take to “make back” the investment. I will concede that it is not a completely meaningless number, but it is unnecessarily crude and, I believe, often misleading.
The key problem with it being that it is hard to come up with a hurdle rate, the number of years a potential investment must pay itself back in to be worth it. The Consumerist believes that the high MPG cars are disappointing, since even the best of them will save you a mere $145 a year.
But even [with] those savings, figured at 12,000 miles/year driven and gas prices of $4/gallon, it would still take more than three years for Focus SFE buyers to recoup the additional $495 cost for the upgrade.
A person has to wonder just how short a recoup period is demanded by The Consumerist to make something a good idea. A year? Six months? Buying something for $495 that will pay you $135 a year is a great deal. It is not as exciting as buying something for $495,000 that will pay $135,000 a year, but it is still a far short of a disappointment.
The right way to tackle this problem and others like it is to consider the dollars paid in and received as an investment and evaluate it relative to other investments. This sort of thing comes up with some frequency in consumer’s lives, when they buy more efficient household appliances or anything with the goal of saving money. It even comes into play when looking at cell phone contracts.
The high MPG version of the Focus will cost an extra $495. You will save $145 a year. For how many years is an important detail. Let us assume six. Perhaps after that you will sell the car, and we will assume the high MPG feature will not increase resale value. So is $495 now in exchange for six annual payments of $145, starting a year from now, a good deal?
Well of course it is. Putting a number on just how good can be done two ways. You can find the internal rate of return (IRR) which is the percentage return on your money of the deal as an investment, or the net present value (NPV) which is what the deal is worth to you right now in dollars, assuming some cost of capital to you. Both are based on the same math, they just solve the algebra for different variables. I will not go through that math here, but Wikipedia does a good job on both IRR and NPV.
For practical purposes, you find IRR (and NPV) using a financial calculator, a spreadsheet, or an online tool. I’m an Excel guy myself, and the =IRR() function tells me the Focus SFE deal returns 18.95% on an annual basis. If you have another use for the $495 that pays higher than that (which is just possible, for example if you have credit card debt you could pay off with it) then take a pass on the high MPG option. Otherwise, go for it.
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By Paul Williams, June 4, 2012 @ 12:33 pm
I’m with you. Even without the proper math, three years isn’t a short enough time period to justify it??? Come on!
Gotta love IRR and NPV though. Those Wikipedia articles do quite a good job with it. I liked the sections on problems with IRR and common pitfalls with NPV.
By Dan, June 4, 2012 @ 1:17 pm
I think this approach makes sense when you’re talking about one investment versus another. But do people really think this way when making consumer purchases? Practically speaking, very few people are going to take the $495 they save on the lower MPG car and put it toward anything, whether it returns a higher rate or not.
So considering the Consumerist’s audience, the vast majority of which are not likely to be hyperefficient investors, they’re probably hitting the right mark here.
By Neil, June 4, 2012 @ 1:41 pm
I management accounting we were taught time to payback as a quick and dirty way to come up with a number while sitting in a meeting. Generally 35 years is considered worthwhile. Less than 3 years basically doesn’t exist. More than five and it’s an “I’ll do some real math and get back to you” problem.
By John W, June 4, 2012 @ 4:22 pm
Remember not too long ago when people dumped their SUV’s, losing $10k$20k in the process, only to buy a Prius at over MSRP? Did they do the math?
By Steve, June 4, 2012 @ 6:29 pm
@John in what way did they lose $1020k? The difference between the price they bought the SUV and the price they sold it? That was a sunk cost.
By Paul Williams, June 5, 2012 @ 1:17 pm
Dan, I’m not sure it matters how they use the money they save. The point here is that you spend $495 today for the equivalent of six annual payments of $145. Regardless of what you do with those payments, you have made a good return on that $495.
Frank, your subscribe to comments plugin doesn’t seem to be working for me. I subscribed when I posted my first comment but I never received any updates about the comments that followed.
By Paul Williams, June 5, 2012 @ 1:39 pm
Dan, I see what you’re saying now. IRR assumes you reinvest at the same rate. But using the MIRR (modified IRR) on this problem with a reinvestment rate of 0%, a finance rate of 6% (cost of capital, or foregone investment return, which is relatively high for this problem), and assuming a 3.5% discount rate when calculating the NPV of the future cash flows, you still get an internal rate of return of 11.83%. I’ll take that.
http://www.wolframalpha.com/input/?i=modified+internal+rate+of+return+calculator&f1=917.65&f=MIRR.PositiveCashFlowNPV_917.65&f2=495&f=MIRR.NegativeCashFlowNPV_495&f3=6+%25&f=MIRR.rfin_6+%25&f4=0+%25&f=MIRR.rR_0+%25&f5=6&x=9&y=11&f=MIRR.compoundingPerN_6
By Junk Car Removal NJ, January 4, 2013 @ 2:12 pm
It comes down to people who understand that math behind purchases and those who don’t. You will either lose value or gain value. I would pay more and go with a hybrid and cut down on gas expense in a market where gas prices are constantly rising. I got hit by Hurricane Sandy and there was a huge Gas problem in NJ. I bet the people with electric and hybrids didn’t lost their cool.
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