Question

The Smert Ad Agency provides cars for its sales staff. In the past, the company has...

The Smert 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. Smert 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.

Smert Ad Agency’s required rate of return is 18%.

1a. What is the net present value of the cash flows associated with the purchase alternative?

__________

1b.. What is the net present value of the cash flows associated with the lease alternative?

__________

Solution 1a and 1b:

 Computation of Present Value of Purchasing alternative and Leasing Alternative Particulars Period Amount PV Factor Present Value Purchasing Option: Purchase price of Car 0 -\$1,60,000 1 -\$1,60,000 Annual cost of Servicing, taxes and licensing 1-3 -\$4,900 2.174 -\$10,653 Repairs - Year 1 1 -\$2,800 0.847 -\$2,372 Repairs - Year 2 2 -\$5,300 0.718 -\$3,805 Repairs - Year 3 3 -\$7,300 0.609 -\$4,446 Sale Value of Car 3 \$80,000 0.609 \$48,720 Net Present Value of Buying Option (A) -\$1,32,555 Leasing Option: Annual lease payment 1-3 -\$68,000 2.174 -\$1,47,832 Security deposit 0 -\$14,000 1 -\$14,000 Return of Security deposit 3 \$14,000 0.609 \$8,526 Net Present Value of Leasing Option (B) -\$1,53,306