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 $20,000 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 $ 5,300
Repairs, first year $ 3,200
Repairs, second year $ 5,700
Repairs, third year $ 7,700


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 $72,000 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 $16,000 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 12B-1 and Exhibit 12B-2, to determine the appropriate discount factor(s) using tables. (Use the tables to get your discount factors. The linked tables are the same tables as the ones in your course packet. If you calculate discount factors using Excel or a financial calculator, your answer may be different enough due to rounding that the system will mark it wrong.)



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

To calculate the NPV of the cash flows associated with the purchase and lease alternatives, we need to determine the present value of each cash flow and subtract the initial costs. The purchase alternative involves purchasing cars, incurring annual costs, and selling the cars after three years. The lease alternative involves leasing cars, making annual lease payments, and receiving a security deposit refund at the end of the lease.

Step-by-step explanation:

To calculate the net present value (NPV) of the cash flows associated with the purchase alternative, we need to determine the present value of the cash flows and subtract the initial cost. The annual cash flows consist of the cost of servicing, taxes, and licensing, as well as the repair costs for each year. Additionally, at the end of three years, the fleet can be sold for half of the original purchase price. We can use the appropriate discount factors from the provided tables to calculate the present value of each cash flow. After calculating all the present values, we sum them up and subtract the initial cost of purchasing the ten cars. The resulting value will be the NPV of the purchase alternative.

To calculate the NPV of the cash flows associated with the lease alternative, we need to determine the present value of the lease payments and subtract the security deposit. The annual lease cost is $72,000, and the security deposit is $16,000. The owner provides all servicing, repairs, taxes, and licensing, so there are no additional costs. Using the appropriate discount factors from the provided tables, we calculate the present value of the lease payments for three years. We then subtract the security deposit from the present value to obtain the NPV of the lease alternative.

After calculating the NPV for both alternatives, we compare the values. If the NPV is positive, it means that the alternative is expected to generate a positive return and should be accepted. If the NPV is negative, the alternative is expected to result in a negative return and should be rejected. Comparing the NPVs of the purchase and lease alternatives will help determine which alternative the company should accept.