The Riteway Ad Agency provides cars for its sales staff. In the past, the compan
ID: 2598288 • Letter: T
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 $28,000 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
$
4,400
Repairs, first year
$
2,300
Repairs, second year
$
4,800
Repairs, third year
$
6,800
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 $63,000 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 $11,500 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.
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.
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.)
Now
1
2
3
Purchase Alternative:
Purchase of cars
Annual servicing costs
Repairs
Resale value of cars
Total cash flows
$0
$0
$0
$0
Discount factor
Present value
0
0
0
0
Net present value
$0
Lease Alternative:
Security deposit
Annual lease payments
Refund of deposit
Total cash flows
Discount factor
Present value
Net present value
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 $28,000 each. If this alternative is accepted, the following costs will be incurred on the fleet as a whole:
Explanation / Answer
1) Calculation of present value cash flows (Amount in $)
The net present value cash outflows of lease alternative($145,627) is lower than net present value of cash outflows of purchase alternative ($210,050). Therefore the lease alternative should be choosed.
Particulars Now Year 1 Year 2 Year 3 Purchase Alternative: Purchase of cars (28,000*10 cars) -280,000 0 0 0 Annual servicing costs -4,400 -4,400 -4,400 Repairs -2,300 -4,800 -6,800 Resale Value of cars (1/2 of 280,000) 140,000 Total Cash flows (A) -280,000 -6,700 -9,200 128,800 Discount Factor (at 16%) (B) 1 0.862 0.743 0.641 Present Value (A*B) -280,000 -5,775 -6,836 82,561 Net Present Value (-280,000-5,775-6,836+82,561) -210,050 Lease Alternative: Security Deposit -11,500 0 0 0 Annual lease payments 0 -63,000 -63,000 -63,000 Refund of deposit 0 0 0 +11,500 Total cash flows (C) -11,500 -63,000 -63,000 -51,500 Discount Factor (D) 1 0.862 0.743 0.641 Present Value (C*D) -11,500 -54,306 -46,809 -33,012 Net Present Value (-11,500-54,306-46,809-33,012) -145,627Related Questions
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