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 $ 5,500

Repairs, first year $ 3,400

Repairs, second year $ 5,900

Repairs, third year $ 7,900

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 $74,000 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 $17,000 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%.

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

a. Calculating Net Present Value of cash outflow with Purchase Alternative.

Year	Particulars	Cash Outflow (Inflow)	PV Factor @18%	Discounted Cash Flow
0	Purchase 10 Cars	$150,000	1.0000	$150,000
1	Repairs, first year	3400	0.8475	2881.50
1	Annual cost of servicing, taxes, and licensing	5500	0.8475	4661.25
2	Repairs, second year	5900	0.7182	4237.38
2	Annual cost of servicing, taxes, and licensing	5500	0.7182	3950.10
3	Repairs, third year	7900	0.6086	4807.94
3	Annual cost of servicing, taxes, and licensing	5500	0.6086	3347.30
3	Terminal Value of Fleet	(75000)	0.6086	(45645.00)
	Net Present Value of outflow in Purchase alternative			$128,240.47

Answer 2. Calculating Net Present Value of cash outflow with Lease Alternative.

Year	Particulars	Cash Outflow (Inflow)	PV Factor @18%	Discounted Cash Flow
0	Security Deposit	$17,000	1.0000	$17,000
1	Lease rental, first year	74000	0.8475	62715.00
2	Lease rental, Second year	74000	0.7182	53146.80
3	Lease rental, third year	74000	0.6086	45036.40
3	Security Deposit refunded	(17000)	0.6086	(10346.20)
	Net Present Value of cash outflow in lease alternative			$167,552.00

Answer 3.

Considering the Net present value under both alternatives, it is recommended that company should accept Purchase alternative because its Net present value of Cash outflow is Minimum.

Note:- Present Value (PV) factor 18% have been considered to 4 decimal points.

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