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 $26,000 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	$	4,200
Repairs, first year	$	2,100
Repairs, second year	$	4,600
Repairs, third year	$	6,600

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 $61,000 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 20%.

Click here to view Exhibit 12B-1 and Exhibit 12B-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

1. Net Present Value of the cash Flows associated with the purchase alternative

Year	Purchase Cost	Annual service Cost	Repair	Sale of Car	Net casah outflow	PV@ 20%	Present Value
0	260000				260000	1	260000
1		4200	2100		6300	0.833	5250
2		4200	4600		8800	0.694	6111
3		4200	6600	-130000	-119200	0.579	-68981
			Net Present Value under Purchase Option				2,02,380

2.  Net Present Value of the cash Flows associated with the lease alternative

Year	Lease Cost	Security Deposit	Net casah outflow	PV@ 20%	Present Value
0		10500	10500	1	10500
1	61000		61000	0.833	50833
2	61000		61000	0.694	42361
3	61000	-10500	50500	0.579	29225
	Net Present Value under Lease Option				1,32,919

3. Lease Option is much better because Net Present Value of Cash outflow is less. The Company should select Lease option.