The Wrongway Ad Agency provides cars for its sales staff. In the past, the compa

Question

The Wrongway 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 as follows 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 $18,400 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 Repairs, year 1 Repairs, year 2 Repairs, year 3 $6,750 1.750 5,550 6,975 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 $61,500 per year (with 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. Wrongway would be required to make a $11,250 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. Wrongway's required rate of return is 18% Click here to view Exhibit 10-1 and Exhibit 10-2, to determine the appropriate discount factor(s) using tables equired: (Ignore income taxes.) 1. Use the total cost approach to determine the present value of the cash flows associated with each alternative. (Negative amounts should be indicated with a minus sign. Round discount factor(s) to 3 decimal places. Round other intermediate calculations and final answers to the nearest whole dollar amounts.) Present Value of Cash Flows Purchase of fleet Lease of cars 2. Which alternative should the company accept based on the calculations in part (1)? Purchase of fleet Lease of cars

Explanation / Answer

Solution 1:

Solution 2:

As present value of cash outflow in leasing option is lesser than present value of cash outflows of purchasing option. Therefore company should accept lease alternative.

Computation of Present Value of Purchasing and Leasing option - Wrong way Ad Agency Particulars Period Amount PV Factor Present Value Purchasing Option: Purchase price of Car 0 $184,000.00 1 $184,000 Annual cost of Servicing, taxes and licensing 1-3 $6,750.00 2.174 $14,675 Repairs - Year 1 1 $1,750.00 0.847 $1,482 Repairs - Year 2 2 $5,550.00 0.718 $3,985 Repairs - Year 3 3 $6,975.00 0.609 $4,248 Sale Value of Car 3 -$92,000.00 0.609 -$56,028 Present Value of Buying Option (A) $152,361 Leasing Option: Annual lease payment 1-3 $61,500.00 2.174 $133,701 Security deposit 0 $11,250.00 1 $11,250 Return of Security deposit 3 -$11,250.00 0.609 -$6,851 Present Value of Leasing Option (B) $138,100

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