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 $31,000 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	$	4,700
Repairs, first year	$	2,600
Repairs, second year	$	5,100
Repairs, third year	$	7,100

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 $66,000 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 $13,000 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 16%.

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

	Period	PV Factor	Amount	Present value
Purchase price	0	1	- 310,000	-310,000
Annual cost of servicing	1-3	2.246	- 4,700	- 10,556
Repairs Year 1	1	0.862	-2,600	- 2,241
Repairs year 2	2	0.743	-5,100	- 3,789
Repairs year 3	3	0.641	-7,100	- 4,551
Sale value of car	3	0.641	155,000	99,355
Present value of buying option				- 231,782

	Period	PV Factor	Amount	Present value
Annual lease payment	1-3	2.246	- 66,000	- 148,236
Security deposit	0	1	- 13,000	- 13,000
Return of security deposit	3	0.641	13,000	8,333
Present value of leasing option				- 152,903

The company should accept lease alternative