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	$	4,800
Repairs, first year	$	2,700
Repairs, second year	$	5,200
Repairs, third year	$	7,200

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 $67,000 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 $13,500 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 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

Requirement 1: Compute the net present value of the cash flows associated with the purchase alternative as follows

Particulars	Year 0	Year 1	Year 2	Year 3
Cost of Cars ($15,000 × 10 Cars)	($150,000)
Service Costs, Taxes and Licensing		($4,800)	($4,800)	($4,800)
Repairs		($2,700)	($5,200)	($7,200)
Salvage Value of Cars ($150,000 ÷ 2)				$75,000
Total Cash Flows	($150,000)	($7,500)	($10,000)	$63,000
× Present Value Factor of $1 @ 17%	1.000	0.855	0.731	0.624
Present Value	($150,000)	($6,413)	($7,310)	$39,312
Net Present Value	($124,411)

Requirement 2: Compute the net present value of the cash flows associated with the lease alternative as follows

Particulars	Year 0	Year 1	Year 2	Year 3
Security Deposit	($13,500)
Annual Lease Payments		($67,000)	($67,000)	($67,000)
Refundable Deposit				$13,500
Total Cash Flows	($13,500)	($67,000)	($67,000)	($53,500)
× Present Value Factor of $1 @ 17%	1.000	0.855	0.731	0.624
Present Value	($13,500)	($57,285)	($48,977)	($33,384)
Net Present Value	($153,146)

Requirement 3: The company should accept the purchase alternative as the cost of operating cars is lower when compared to lease alternative.

Note: Pick the following highlighted present value factors for the above computations.