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	$	3,000
Repairs, first year	$	1,500
Repairs, second year	$	4,000
Repairs, third year	$	6,000

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 $55,000 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 $10,000 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

Solution 1&2:

Computation of Present Value of Purchasing and Leasing option - Riteway Ad Agency
Particulars	Period	Amount	PV Factor	Present Value
Purchasing Option:
Purchase price of Car	0	-$170,000.00	1	-$170,000.00
Annual cost of Servicing, taxes and licensing	1-3	-$3,000.00	2.174	-$6,522.00
Repairs - Year 1	1	-$1,500.00	0.847	-$1,270.50
Repairs - Year 2	2	-$4,000.00	0.718	-$2,872.00
Repairs - Year 3	3	-$6,000.00	0.609	-$3,654.00
Sale Value of Car	3	$85,000.00	0.609	$51,765.00
Net Present Value of Buying Option (A)				-$132,553.50
Leasing Option:
Annual lease payment	1-3	-$55,000.00	2.174	-$119,570.00
Security deposit	0	-$10,000.00	1	-$10,000.00
Return of Security deposit	3	$10,000.00	0.609	$6,090.00
Net Present Value of Leasing Option (B)				-$123,480.00

Solution 3:

As net present value of lease option is higher than net present value of buying option, therefore company should accept lease alternative.