Question

The Wrongway 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 as follows:

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 $20,000 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	$	5,250
Repairs, year 1		2,200
Repairs, year 2		4,900
Repairs, year 3		6,900

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 $66,750 per year (with 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. Wrongway would be required to make a $12,250 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.

Wrongway’s required rate of return is 18%.

  

Click here to view Exhibit 10-1 and Exhibit 10-2, to determine the appropriate discount factor(s) using tables.

  

Required:
(Ignore income taxes.)
1.	Use the total cost approach to determine the present value of the cash flows associated with each alternative. (Negative amounts should be indicated with a minus sign. Round discount factor(s) to 3 decimal places. Round other intermediate calculations and final answers to the nearest whole dollar amounts.)

Answer 1

Calculation of the present value of the cash flows associated with purchase alternative
Year	0	1	2	3	NPV
Purchase cost of cars	-$200,000
Cost of servicing,taxes and licensing		-$5,250	-$5,250	-$5,250
Repairs		-$2,200	-$4,900	-$6,900
Sale value of cars				$100,000
Net Cash flows	-$200,000	-$7,450	-$10,150	$87,850
Discount factor @ 18%	1	0.847	0.718	0.609
Present Values	-$200,000.00	-$6,313.56	-$7,289.57	$53,468.22	-$160,134.91
Calculation of the present value of the cash flows associated with lease alternative
Year	0	1	2	3
Lease rental		-$66,750.00	-$66,750.00	-$66,750.00
Security deposit	-$12,250.00
Refund of security deposit				$12,250.00
Net Cash flows	-$12,250.00	-$66,750.00	-$66,750.00	-$54,500.00
Discount factor @ 18%	1	0.847	0.718	0.609
Present Values	-$12,250.00	-$56,567.80	-$47,938.81	-$33,170.38	-$149,926.99
The present value of cash flows is lower in Lease alternative , hence Wrongway Ad Agency should choose lease alternative.