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 $15,000 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	$	3,100
Repairs, first year	$	1,000
Repairs, second year	$	3,500
Repairs, third year	$	5,500

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 $50,000 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 $10,500 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 19%.

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

Given information for purchase option:

Number of cars to be purchased = 10 cars

Discounted price of each car = $15,000 per car

Total cost of cars = $15,000 * 10 cars = $150,000

Annual cost of servicing, taxes and licensing = = $3,100

Repairs, first year = $1,000

Repairs, second year = $3,500

Repairs, third year = $5,500

Sale value of Cars at the end of 3 years = $150,000 / 2 = $75,000

1. Net present value (NPV) of the cash flows associated with the purchase alternative is:

Year	Particulars	Cashflow ($)	Discounting Factor @ 19%	Present Value ($)
(A)	(B)	(C )	(D)	(E = C * D)
Year 0	Purchase Cost of total cars	($150,000)	1	($150,000)
Year 1 - 3	Annual cost of servicing, taxes and licensing	($3,100)	2.1399	($6,634)
Year 1	Repairs	($1,000)	0.8403	($840)
Year 2	Repairs	($3,500)	0.7062	($2,472)
Year 3	Repairs	($5,500)	0.5934	($3,264)
Year 3	Sales value of cars	$75,000	0.5934	$44,505
	Net Present Value (NPV)			($118,704)

The Net Present Value (NPV) from the purchase option is ($118,704).

2. Net present value (NPV) of the cash flows associated with the lease alternative is:

Annual lease cost = $50,000 per year

Lease term = 3 years

Discounting factor = 19%

Refundable Security deposit to be paid at the beginning of the lease term = $10,500

Year	Particulars	Cashflow ($)	Discounting Factor @ 19%	Present Value ($)
(A)	(B)	(C )	(D)	(E = C * D)
Year 0	Security deposit	($10,500)	1	($10,500)
Year 1 - 3	Lease Charges	($50,000)	2.1399	($106,995)
Year 3	Recovery of Security deposit	$10,500	0.5934	$6,231
	Net Present Value (NPV)			($111,264)

The Net Present Value (NPV) from the lease option is ($111,264).

3. Acceptance of alternative:

	$
Present value of cash outflows under Purchase Option	$118,704
Present value of cash outflows under Lease Option	$111,264

Decision: The Riteway Ad Agency should acquire the cars on Lease because the present value of cash outflows are lower under the Lease Option when compared with the Purchase Option.