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 $23,000 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	$	3,900
Repairs, first year	$	1,800
Repairs, second year	$	4,300
Repairs, third year	$	6,300

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 $58,000 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 $14,500 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 17%.

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
	Year(s)	Amount	PV factor	Present Value
Purchase Alternative:
Purchase of cars	Now	-230000	1	-230000
Annual servicing costs	1-3	-3900	2.210	-8619
Repairs:
First year	1	-1800	0.855	-1539
Second year	2	-4300	0.731	-3143
Third year	3	-6300	0.624	-3931
Resale value of cars	3	115000	0.624	71760
Net present value				-175473
2
Lease Alternative:
Security deposit	Now	-14500	1	-14500
Annual lease payments	1-3	-58000	2.210	-128180
Refund of deposit	3	14500	0.624	9048
Net present value				-133632
3
The company should lease as lease alternative has higher net present value