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 $17,000 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 Repairs, first year Repairs, Second year Repairs, third year $ 3,300 $ 1.200 $ 3.700 55,700 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 552,000 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 $11,50 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 17% 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

Purchase Alternative Cost of purchase for 10 cars =: $17000 X 10= $170000 Sale price after 3 years : 1/2 of the purchase price i.e. $ 8500 each ($17000 X 1/2) Sale price for 10 cars = $8500 X 10= $85000 Cost PV Factor @ 17% -$1,70,000 1 -$4,500 0.8547 $7,000 0.7305 $76,000 0.62437 Total Present value of Cash Flow -$1,70,000 -$3,846 -$5,114 $47,452 -$1,31,508 Cost for year 1 Cost for year 2 $3300+ $1200 =$4500 $3300+$3700 = $7000 $3300+ $5700 = $9000 $9000 is outflow, however receipt of sale price of car is $ 85000 therefore net cash inflow = $85000 - $9000 = $76000 Cost for year 3

Lease Alternative: Year 1 Cost -$11,500 -$52,000 -$52,000 -$40,500 Total PV Factor @ 17% 1 0.8547 0.7305 0.62437 Present value of Cash Flow -$11,500 -$44,444 -$37,986 -$25,287 -$1,19,217 Cash flow for year 3 = $52000 less receipt of deposit of $11500 i.e. $52000-$11500 = $40500 NPV for lease alternative is -$119217 As net cash outflow is less in lease alternative therefore lease alternative should be accepted Note: in the absense of exhibit 13 B-1 & 2, PV factor is calculated on general basis Year (1+r)^n PV factor = (1/ (1+r)^n] 1.17 0.854700855 1.3689 0.730513551 1.601613 0.624370556 2

Present value = PV factor X cost