Question

Problem 13-25 Net Present Value Analysis of a Lease or Buy Decision [LO13-2]

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 13B-1 and Exhibit 13B-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

		The Riteway Ad Agency
Ans
1	Years	Purchase	Value	PV value @ 20%	PV value
		Cost of purchase of car
		(26000*10)	$    2,60,000.00	1.00000	$      2,60,000.00
	1 years	Annual cost of servicing, taxes, and licensing $ 4,200	$          4,200.00	0.83333	$            3,500.00
		Repairs, first year $ 2,100 Repairs	$          2,100.00	0.83333	$            1,750.00
	2 years	Annual cost of servicing, taxes, and licensing $ 4,200	$          4,200.00	0.69444	$            2,916.67
		second year $ 4,600 Repairs	$          4,600.00	0.69444	$            3,194.44
	3 years	third year $ 6,600 for repair	$          6,600.00	0.57870	$            3,819.44
		Annual cost of servicing, taxes, and licensing $ 4,200	$          4,200.00	0.57870	$            2,430.56
		At the end of three years, the fleet could be sold for one-half of the original purchase price			$                         -
		(260000/2)	$   -1,30,000.00	0.57870	$        -75,231.48
		Net present Value	$    1,55,900.00		$      2,02,379.63
2	Years	Lease contract	Value	PV value @ 20%	PV value
	1 years	Security Deposit	10500	1.00000	$          10,500.00
		Lease cost	61000	0.83333	$          50,833.33
	2 years	Lease cost	61000	0.69444	$          42,361.11
	3 years	Lease cost	61000	0.57870	$          35,300.93
		Return of Security deposit	-10500	0.57870	$           -6,076.39
		Net present Value	183000		$      1,32,918.98
3	As per above calculation Lease agreement is cheaper then buying alternative