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 $17,000 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, first year Repairs, second year Repairs, third year 3,000 $ 1,500 $ 4,000 $ 6,000 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 $55,000 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%. Click here to view Exhibit 11B-1 and Exhibit 11B-2, to determine the appropriate discount factor(s) using tables.

Explanation / Answer

Leasing Alternative is better

Now year 1 year 2 year 3 Purchase of cars $ (170,000) Annual Serviving costs     $   (3,000) $   (3,000) $   (3,000) Repairs $   (1,500) $   (4,000) $   (6,000) Resale value of cars $   85,000 Total cash flows $ (170,000) $   (4,500) $   (7,000) $   76,000 Discount factor 1 0.847 0.718 0.609 present value $ (170,000) $   (3,812) $   (5,026) $   46,284 net present value $ (132,554) Leasing Now year 1 year 2 year 3 Security Deposit $   (10,000) Annual Lease payment $ (55,000) $ (55,000) $ (55,000) Refund of Deposit $   10,000 Total cash flows $   (10,000) $ (55,000) $ (55,000) $ (45,000) Discount factor 1 0.847 0.718 0.609 present value $   (10,000) $ (46,585) $ (39,490) $ (27,405) net present value $ (123,480)

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