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 $19,000 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	$	3,500
Repairs, first year	$	1,400
Repairs, second year	$	3,900
Repairs, third year	$	5,900
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 $54,000 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 $12,500 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 18%. Use Excel or a financial calculator to solve. Required: PART1. Use the total-cost approach to determine the present value of the cash flows associated with each alternative. (Any cash outflows should be indicated by a minus sign. Round to the nearest dollar.) Now 1 2 3 Purchase Alternative: Purchase of cars Annual servicing costs Repairs Resale value of cars Total cash flows $0 $0 $0 $0 Net present value Lease Alternative: Security deposit Annual lease payments Refund of deposit Total cash flows $0 $0 $0 $0 Net present value PART2. Which alternative should the company accept? Purchase alternative Lease alternative

Answer 1

1. Net Present value calculation:
	Now	1	2	3
Purchase Alternative:
Purchase of cars	($190,000)	-	-	-
Annual servicing costs	-	($3,500)	($3,500)	($3,500)
Repairs	-	($1,400)	($3,900)	($5,900)
Resale value of cars	-	-	-	$95,000
Total cash flows	($190,000)	($4,900)	($7,400)	$85,600
Discount factor	1	0.847	0.718	0.609
Present value	($190,000.00)	($4,150.30)	($5,313.20)	$52,130.40
Net present value	($147,333.10)
Lease Alternative:
Security deposit	($12,500)	-	-	-
Annual lease payments	-	($54,000)	($54,000)	($54,000)
Refund of deposit	-	-	-	$12,500
Total cash flows	($12,500)	($54,000)	($54,000)	($41,500)
Discount factor	1	0.847	0.718	0.609
Present value	($12,500.00)	($45,738.00)	($38,772.00)	($25,273.50)
Net present value	($122,283.50)

(2) Lease alternative has the lowest NPV (-$122,283.50) as compared with purchase alternative (-$147333.10) Therefore, lease alternative should be accepted.