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 $28,000 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	$	4,400
Repairs, first year	$	2,300
Repairs, second year	$	4,800
Repairs, third year	$	6,800

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 $63,000 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 $11,500 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 16%.

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

Solutions:

The Riteway Ad Agency
Purchase Alternative	Initial Investment / Sales Price end of third year	Annual Cost	Repairs	Total Cash Outflows	PV factor @ 16%	PV of Cash Outflows
0	-280000			-280000	1.00000	-280000
1		-4400	-2300	-6700	0.86207	-5776
2		-4400	-4800	-9200	0.74316	-6837
3		-4400	-6800	-11200	0.64066	-7175
3	140000			140000	0.64066	89692
PV of Cash Outflows						-210096

Lease Alternative	Cash Outflows	PV factor @ 16%	PV of Cash Outflows
0	-11500	1.00000	-11500
1	-63000	0.86207	-54310
2	-63000	0.74316	-46819
3	-63000	0.64066	-40361
3	11500	0.64066	7368
PV of Cash Outflows			-145623

The PV of cash outflows for lease option is lesser when compared to Purchase alternative. i.e, The NPV in favor of lease of cars is $64473 ($210096 - $145623). Hence the company should accept lease alternative

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