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 $16,000 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	$	4,900
Repairs, first year	$	2,800
Repairs, second year	$	5,300
Repairs, third year	$	7,300

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 $68,000 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 $14,000 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 18%.

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

Ans:

Particulars	Now	Year 1	Year 2	Year 3
1.Purchase Alternative
Purchase of Cars	-160,000
Annual Servicing Cost		-4900	-4900	-4900
Repair		-2800	-5300	-7300
Resale Value of Cars				80,000
Total Cash Outflows	-160,000	-7700	-10200	67,800
Discount Factor @18%	1	0.847	0.718	0.609
Present Value	-160,000	-6521.9	-7323.6	41,290
Net Present Value of Outflows	-132,555
2.Lease Alternative
Security Deposits	-14,000
Annual Lease Payments		-68,000	-68,000	-68,000
Refund of Security Deposits				14000
Total Cash Outflows	-14,000	-68,000	-68,000	-54,000
Discount Factor@18%	1	0.847	0.718	0.609
Present Value	-14,000	-57596	-48824	-32,886
Net Present Value	-153,306
3.It is better to Purchase the cars rather than leasing   as the present value
of cash outflows is more in Lease alternative compared to Purchase alternative