Question

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:

Purchase alternative:

The company can purchase the cars, as in the past, and sell the cars after three years of use. Ten cars will be needed, which can be purchased at a discounted price of $30,000 each. If this alternative is accepted, the following costs will be incurred on the fleet as a whole:

Annual cost of servicing, taxes, and licensing	$	4,600
Repairs, first year	$	2,500
Repairs, second year	$	5,000
Repairs, third year	$	7,000

At the end of three years, the fleet could be sold for one-half of the original purchase price.

Lease alternative:

The company can lease the cars under a three-year lease contract. The lease cost would be $65,000 per year (the first payment due at the end of Year 1). As part of this lease cost, the owner would provide all servicing and repairs, license the cars, and pay all the taxes. Riteway would be required to make a $12,500 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 14%.

Click here to view Exhibit 13B-1 and Exhibit 13B-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 the lease alternative?

3. Which alternative should the company accept?

Answer 1

C D E Purchase alternative 0 -300000 1 2 3 -4600 -2500 -4600 -5000 A 1 2 Year 3 Purchase cost 4 Annual cost of servicing, taxes, and licensing 5 Repairs 6 Resale value of the cars 7 Total Cash flows 8 Multiply: Present Value factor @ 14% 9 Present Value 10 Net present value 11 -46001 -7000 150000 138400 0.675 93420 -300000 -7100 0.877 -6226.7| -9600 0.769 -7382.4 -300000 -220189 12 Lease alternative 0 -12500 1 2 3 -65000 -65000 13 Year 14 Security deposit 15 Annual Lease payment 16 Refund of Security deposit 17 Total Cash flows 18 Multiply: Present Value factor @ 14% 19 Present Value 20 Net present value -12500 -65000 0.877 -57005 -65000 0.769 -49985 -65000 12500 -52500 0.675 -35437.5 -12500 -154927.5 21 22 Which alternative should the company accept? 23 Lease Alternative 24 Hint: Lease option has Lower Present value of net Cash outflow.

C D E Purchase alternative 1 2 3 |-300000 -4600 -2500 - 4600 -5000 1 2 Year 3 Purchase cost 4 Annual cost of servicing, taxes, and licensing 5 Repairs 6 Resale value of the cars 7 Total Cash flows 8 Multiply: Present Value factor @ 14% 9 Present Value 10 Net present value -4600 |-7000 =300000/2 =E4+E5+E6 10.675 =E7*E8 =B3 =C4+C5 =D4+D5 0.877 0.769 =C7*C8 =D7*D8 =B7*B8 =B9+C9+D9+E9 11 12 Lease alternative 13 Year 14 Security deposit -12500 15 Annual Lease payment 16 Refund of Security deposit 17 Total Cash flows -12500 18 Multiply: Present Value factor @ 14% 19 Present Value =B17*B18 20 Net present value =B19+C19+D19+E19 21 22 Which alternative should the company accept? 23 Lease Alternative 24 Hint: Lease option has Lower Present value of net Cash outflow. -65000 -65000 -65000 12500 -65000 -65000 =E15+E16 0.877 10.769 0.675 =C17*C181=D17*D18 1=E17*E18