Question

Problem 12-25 Net Present Value Analysis of a Lease or Buy Decision [LO12-2] The Riteway Ad Agency provides cars for its sales staff. In the past, the company has always purchased its cars from a dealer and then sold the cars after three years of use. The company's present fleet of cars is three years old and will be sold very shortly. To provide a replacement fleet, the company is considering two alternatives The company can purchase the cars, as in the past, and sell the cars after three years of use. Ten cars wi11 be needed, which can be purchased at a discounted price of $27,000 each. If this alternative is accepted, the following costs will be incurred on the fleet as a whole: Purchase alternative: Annual cost of servicing, taxes, and 1icensing Repairs, first year Repairs, second year Repairs, third year $ 4,300 $ 2,200 $ 4,700 $ 6,700 At the end of three years, the fleet could be sold for one-half of the original purchase price Lease al ternative: The company can lease the cars under a three-year 1ease contract. The lease cost would be $62,e00 per year (the first paynent due at the end of Year 1). As part of this lease cost, the ouner would provide all servicing and repairs, 1icense the cars, and pay all the taxes. Riteway would be required to make a $11,000 security deposit at the beginning of the lease period, which would be refunded when the cars were returned to the owner at the end of the lease contract. Riteway Ad Agency's required rate of return is 15 %. Click here to view Exhibit 128-1 and Exhibit 128.2, to determine the appropriate discount factor(s) using tables Required: 1. What is the net present value of the cash flows associated with the purchase alternative? 2. What is the net present value of the cash flows associated with th 3. Which alternative should the company accept? alternative?

Answer 1

(a)

Purchase cost of 10 cars = $27,000 * 10

= $270,000

Annual cost of servicing, taxes & licensing = $4,300

Repairs, first year = $2,200

Repairs, second year = $4,700

Repairs, third year = $6,700

Total cost related to servicing and repairs

First year = $6,500

Second year = $9,000

Third year = $11,000

Resale value of cars after 3 years = One -half of original purchase price i.e. $135,000

Discounting rate = 15%

PV of cash flows associated (Purchase) = $230,000 + ($6,500 * 0.870) + ($9,000 * 0.756) + ($11,000 * 0.658) - ($135,000 * 0.658)

PV of cash outflows = $230,000 + $5,655 + $6,804 + $7,238 - $88,830

= $160,867

(b)

Refundable Security Deposit = $11,000

Annual lease payments = $62,000

PV of cash outflow (Lease) = security deposit + PV of lease payments - PV of security deposit refund

= $11,000 + ($62,000 * 2.283) - ($11,000 * 0.658)

= $11,000 + $141,546 - $7,238

= $145,308

(c)

The company should accept the Lease alternative because the present value of cash outflow is lower in lasing option as compared to purchase option.