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 $23,000 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	$	3,900
Repairs, first year	$	1,800
Repairs, second year	$	4,300
Repairs, third year	$	6,300

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 $58,000 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 $14,500 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

Solution:

1. Calculation of NPV of Cash flow at Purchase Alternative

Particulars	Present ( 0 yr)	1st Year	2 Year	3rd Year
Purchasse of Car( 23,000 *10 )	-230,000
Annual cost of servicing, taxes, and licensing		-3,900	-3,900	-3,900
Repairs		-1,800	-4,300	-6,300
Sale Price of Fleet [(23000/2) * 10]				115,000
Total Cash flow	-230,000	-5,700	-8,200	104,800
P V Factor of $1 @ 17%	1.00	0.855	0.731	0.624
Net Present Value of Cash Flow	-230,000	-4873.50	-5,994.20	65,395.20

Total Present Value of Cash Flows= -230,000 - 4873.50 - 5,994.20 + 65,395.20

= - $175,472.50

2) Calculation of NPV of Cash flow at Lease Alternative

Particulars	Present ( 0 yr)	1st Year	2 Year	3rd Year
Annual Lease Cost		-58,000	-58,000	-58,000
Security Deposit	-14,500
Refund of Security Deposit				14,500
Total Cash flow	-14,500	-58,000	-58,000	-43,500
P V Factor of $1 @ 17%	1.00	0.855	0.731	0.624
Net Present Value of Cash Flow	-14,500	- 49,590	-42,398	-27,144

Total Present Value of Cash Flows : - 14500 - 49,590 - 42,398 - 27,144

= -$133,632

3.) Chosing the Alternative

As calculated above, net present value of Cash outflows from Lease alternative (-$133,632) is lesser than the purchase alternative (-$175,472.50). It means company has to pay less if It goes with lease alternative, so it should accept the lease alternative.