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

Ans:

Particulars	Now	Year 1	Year 2	Year 3
1.Purchase Alternative
Purchase of Cars	-260,000
Annual Servicing Cost		-4200	-4200	-4200
Repair		-2100	-4600	-6600
Resale Value of Cars				130,000
Total Cash Outflows	-260,000	-6300	-8800	119,200
Discount [email protected]	1	0.833	0.694	0.579
Present Value	-260,000	-5247.9	-6107.2	69,017
Net Present Value of Outflows	-202,338
2.Lease Alternative
Security Deposits	-10,500
Annual Lease Payments		-61,000	-61,000	-61,000
Refund of Security Deposits				10500
Total Cash Outflows	-10,500	-61,000	-61,000	-50,500
Discount [email protected]	1	0.833	0.694	0.579
Present Value	-10,500	-50813	-42334	-29,240
Net Present Value	-132,887
3.It is better to lease the cars rather than Purchasing as the present value of cash outflows is more in Purchase alternative compared to lease alternative

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