Problem 13-25 Net Present Value Analysis of a Lease or Buy Decision IL013-2? The
ID: 2527052 • Letter: P
Question
Problem 13-25 Net Present Value Analysis of a Lease or Buy Decision IL013-2? 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 $21,000 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$3,700 Repairs, first year Repairs, second year Repairs, third year $1,600 $4,100 $6,100 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 $56,000 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 $13,500 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 15%. Click here to view Exhibit 13B-1 and Exhibit 13B-2, to determine the appropriate discount factor(s) using tablesExplanation / Answer
1
Alternative -1
Net present value of cash outflows
Particulars
Amount
P.V/Annuity factor
Discounted cash flows
Purchase cost
$210,000
1
$210,000
Annual maintenance cost
$3,700
2.28323
$8,448
Repairs 1st year
$1,600
0.8696
$1,391
Repairs 2nd year
$4,100
0.7561
$3,100
Repairs 3rd year
$6,100
0.6575
$4,011
Salvage value (21,000/2)
($105,000)
0.6575
($69,038)
Total
$157,913
2
Alternative -2
Net present value of cash outflows
Particulars
Amount
P.V/Annuity factor
Discounted cash flows
security deposit
$13,500
1
$13,500
Annual lease cost
$56,000
2.28323
$127,861
Security deposit inflow
($13,500)
0.6575
($8,876)
Total
$132,485
3
Which alternative should the company accept
Ans
Alternative -2
Since the present value of cash outflows is less than alternative -1
1
Alternative -1
Net present value of cash outflows
Particulars
Amount
P.V/Annuity factor
Discounted cash flows
Purchase cost
$210,000
1
$210,000
Annual maintenance cost
$3,700
2.28323
$8,448
Repairs 1st year
$1,600
0.8696
$1,391
Repairs 2nd year
$4,100
0.7561
$3,100
Repairs 3rd year
$6,100
0.6575
$4,011
Salvage value (21,000/2)
($105,000)
0.6575
($69,038)
Total
$157,913
2
Alternative -2
Net present value of cash outflows
Particulars
Amount
P.V/Annuity factor
Discounted cash flows
security deposit
$13,500
1
$13,500
Annual lease cost
$56,000
2.28323
$127,861
Security deposit inflow
($13,500)
0.6575
($8,876)
Total
$132,485
3
Which alternative should the company accept
Ans
Alternative -2
Since the present value of cash outflows is less than alternative -1