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 $16,000 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	$	4,900
Repairs, first year	$	2,800
Repairs, second year	$	5,300
Repairs, third year	$	7,300

  

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 $68,000 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 $14,000 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:
1.	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 $123 $234 $453 $74,664 Annual servicing costs 5,353 78,833 338 7,373 Repairs 7,474 78,474 3,773 7,373 Resale value of cars 42 4,442 3,762 9,882 Total cash flows $12,992 $161,983 $8,326 $99,292 Net present value $636,342 Lease Alternative: Security deposit $872,372 $8,473 $2,323 $4,534 Annual lease payments 3,838 9,393 9,393 2,372 Refund of deposit 8,282 8,348,432 2,822 716,782 Total cash flows $884,492 $8,366,298 $14,538 $723,688 Net present value $872,828

2.	Which alternative should the company accept?
	A Purchase alternative B Lease alternative

Answer 1

Purchase alternative
Particulars	Currency	0	1	2	3	Total
Purchase of Car	$	16,000	-	-	-
Annual cost of servicing, taxes, and licensing	$	-	4,900	4,900	4,900
Repairs	$	-	2,800	5,300	7,300
Total	$	16,000	7,700	10,200	12,200	-
Rate of Return	$	18%	18%	18%	18%
Present value	$	16,000	6,525	7,325	7,425	37,276
Less: Present Sale Value	$					4,869
Net Present Cost	$					32,407
Leased Alternative
Particulars	Currency	0	1	2	3	Total
Security Deposit	$	14,000	-	-	-
Lease Cost	$	-	68,000	68,000	68,000
Total	$	14,000	68,000	68,000	68,000	-
Rate of Return	$	18%	18%	18%	18%
Present value	$	14,000	57,627	48,837	41,387	1,61,851
Less: Security Deposit Refundable	$					8,521
Net Present Cost	$					1,53,330

Purchase Alternative is beneficial