Problem 10-11 Performing an NPV Analysis of a Lease or Buy Decision (LO2 - cc8)

Question

Problem 10-11 Performing an NPV Analysis of a Lease or Buy Decision (LO2 - cc8) 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 $22,000 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 Repairs, year 1 Repairs, year 2 Repairs, year 3 $4,050 1,580 4,850 8,375 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 $72,500 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 $12,750 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.

Explanation / Answer

SOLUTION

1.

(A) The present value of cash flows are under purchase alternative:

(B) The present value of cash flows are under lease alternative:

2. The company should lease the cars because this alternative has the lowest present value of total costs.

Item Years Amount of cash flows ($) (A) 18% factor (B) Present value of cash flows (A*B) Purchase alternative: Purchase cost of the cars ($22,000*10) Now (220,000) 1 (220,000) Annual cost of servicing, etc 1-3 (4,050) 2.174 (8,805) Repairs: First year 1 (1,580) 0.847 (1,338) Second year 2 (4,850) 0.718 (3,482) Third year 3 (8,375) 0.609 (5,100) Resale value of the cars ($220,000*1/2) 3 110,000 0.609 66,990 Present value of cash flows (171,735)

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