Question

Study 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:

  

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 $18,000 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	$	5,100
Repairs, first year	$	3,000
Repairs, second year	$	5,500
Repairs, third year	$	7,500

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 $70,000 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 $15,000 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 20%.

Click here to view Exhibit 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor(s) using tables.

    

Required:

1. Use the total-cost approach to determine the present value of the cash flows associated with each alternative. (Any cash outflows should be indicated by a minus sign. Round discount factor(s) to 3 decimal places.)

	Now	1	2	3
Purchase Alternative:
Purchase of cars
Annual servicing costs
Repairs
Resale value of cars
Total cash flows
Discount factor
Present value
Net present value
Lease Alternative:
Security deposit
Annual lease payments
Refund of deposit
Total cash flows
Discount factor
Present value
Net present value

2. Which alternative should the company accept?

	Purchase alternative
	Lease alternative

Answer 1

	Now	1	2	3
Purchase Alternative:
Purchase of cars	-180000
Annual servicing costs		-5100	-5100	-5100
Repairs		-3000	-5500	-7500
Resale value of cars				90000
Total cash flows	-180000	-8100	-10600	77400
Discount factor	1	0.833	0.694	0.579
Present value	-180000	-6750	-7361	44792
Net present value	-149319
Lease Alternative:
Security deposit	-15000
Annual lease payments		-70000	-70000	-70000
Refund of deposit				15000
Total cash flows	-15000	-70000	-70000	-55000
Discount factor	1	0.833	0.694	0.579
Present value	-15000	-58333	-48611	-31829
Net present value	-153773
The company should accept Purchase alternative as it has better NPV than leasing alternative.