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 8B-1 and Exhibit 8B-2, to determine the appropriate discount factor(s) using tables.

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 discount factor(s) to 3 decimal places.)

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	Now 1 2 3 Purchase Alternative: Purchase of cars Annual servicing costs Repairs Resale value of cars Total cash flows $0 $0 $0 $0 Discount factor Present value 0 0 0 0 Net present value $0 Lease Alternative: Security deposit Annual lease payments Refund of deposit Total cash flows $0 $0 $0 $0 Discount factor Present value 0 0 0 0 Net present value

2. Which alternative should the company accept?

	Purchase alternative
	Lease alternative

Answer 1

Present Value of Cash Flow Using Purchase Alternative
	Year	Cash Flow	P.V.Factor @ 17%	Present Value
Purchase cost of Car ( 23000*10)	1	-230000.00	1	-230000.00
Annual Cost of Servicing	1 to 3	$           3,900	2.210	$            8,619
Repair				$                   -
First year	1	$           1,800	0.855	$            1,539
Second year	2	$           4,300	0.731	$            3,143
Third Year	3	$           6,300	0.624	$            3,931
				$                   -
Resale Value of car ( 230000*50%)	3	$      115,000	0.624	$         71,760
Present Value of Cash flow				-141008
Present Value of Cash Flow Using Lease Alternative
	Year	Cash Flow	P.V.Factor @ 17%	Present Value
Security Deposit	1	-14500	1	-14500.00
Annual Lease Payments	1 to 3	-58000	2.210	-128180.00
Refund of Security Deposit	3	$        14,500	0.624	$            9,048
Present Value of Cash flow				-133632
The company should choose the lease alternative because this alternative has the lowest prsent value of total cost.