The Riteway Ad Agency provides cars for its sales staff. In the past, the compan

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 $19,000 each. If this alternative is accepted, the following costs will be incurred on the fleet as a whole:

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 $54,000 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 $12,500 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.

Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tables.

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.)

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 $19,000 each. If this alternative is accepted, the following costs will be incurred on the fleet as a whole:

Explanation / Answer

Answer 1. Calculation of PV of Cash Flow Year 18% Factor Alternative 1 - Purchase of Car Alternative 2 - Lease of Car Amount PV Amount PV Purchase of Car - 10 Nos 0                 1.0000          190,000          190,000 Cost of Servicing, taxes & licensing 1-3                 2.1743              3,500               7,610 Repairs - First Year 1                 0.8475              1,400               1,187 Repairs - Second Year 2                 0.7182              3,900               2,801 Repairs - Third Year 3                 0.6086              5,900               3,591 Salvage Value of Car - 10 Nos 3                 0.6086          (95,000)          (57,817) Payment of Security deposit 0                 1.0000          12,500          12,500 Lease Rent 1-3                 2.1743          54,000        117,412 Refund of Security Deposit 3                 0.6086        (12,500)          (7,608) Total PV of Cash Flow          147,371        122,305 Answer 2. Lease Alternative should be Accepted PV of cash outflow is less in Lease Alternative ($122305) than Purchase Aleternative ($147371)

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