PROBLEM 8 The Riteway Ad Agency provides cars for its sales staff In the past, t

Question

PROBLEM 8 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 Annual cost of servicing, taxes, and licensing Repairs, first year . Repatrs, second year Repairs, third year $3,000 $1,500 $4,000 56,000 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 $17.000 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 S55,000 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 $10,000 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 18% Required 1. Determine the present value of the cash flows associated with each alternative. Round all dollar amounts to the nearest whole dollar 2. Which alternative should the company accept?

Explanation / Answer

a) The Present value of cash flows are under purchase option Particulars Years Amount of cash flows Discount factor @ 18% Present value of cash flows Purchase cost (17000*10) 0 -170000 1 -170000 Annual cost of servicing 1 to 3 -3000 2.174 -6522 Repairs 1st Year 1 -1500 0.847 -1270.5 2nd Year 2 -4000 0.718 -2872 3rd year 3 -6000 0.609 -3654 Resale Value 3 85000 0.609 51765 Present value of cash flows          (132,553.50) b) Present value of cash flows under lease option Security Deposit 0 -10000 1 -10000 Annual lease payments 1 to 3 -55000 2.174 -119570 Refund of deposit 3 10000 0.609 6090 Present value of cash flows -123480 The company should opt for lease option since the present value of cash flows is lower than the purchase option

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