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 $18,000 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	$	3,400
Repairs, first year	$	1,300
Repairs, second year	$	3,800
Repairs, third year	$	5,800

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 $53,000 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 $12,000 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 14%.

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)Purchase alternative	Cash Flows	Year	PVF	Present value
Purchase Price	(54,000)	1	1	(54,000.00)
Annual cost (PVF for 3 Years)	(3,400)	1&2&3	2.322	(7,893.55)
Repair Year One	(1,300)	1	0.877	(1,140.35)
Repair Year 2	(3,800)	2	0.769	(2,923.98)
Repair Year 3	(5,800)	3	0.675	(3,914.83)
Sale Value	27,000	3	0.675	18,224.23
			NPV	(51,648.48)
2)Lease Alternative	Cash Flows	Year	PVF	Present value
Lease Payment	(53,000)	1&2&3	2.322	(123,046.50)
Secuirity Deposit	(12,000)	1	1	(12,000.00)
Secuirity Deposit Refunded	12,000	3	0.675	8,099.66
			NPV	(126,946.84)

Note:-Negative Means Cost and Positive means cash inflows  

3) Purchase Alternative is Better since in this case we are Taking Decison with cost therefore lesser present value of cost means lesser Better.

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