Problem 13-25 Net Present Value Analysis of a Lease or Buy Decision [LO13-2] The
ID: 2587776 • Letter: P
Question
Problem 13-25 Net Present Value Analysis of a Lease or Buy Decision [LO13-2] 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 $ 1,600 Repairs, second year $ 4,100 Repairs, third year $ 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 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.)
2. Which alternative should the company accept? Lease alternative or Purchase alternative
Explanation / Answer
1 Present value of cashflows Purchase alternative: Year Amount Present value @ 15% Present value of cashflows Initial purchase cost 0 -210000 1 -210000 (21000*10) Annual cost 1 to 3 -3700 2.283225 -8448 Repairs 1 -1600 0.869565 -1391 2 -4100 0.756144 -3100 3 -6100 0.657516 -4011 Sale value 3 105000 0.657516 69039 (210000/2) Total -157911 Lease alternative: Year Amount Present value @ 15% Present value of cashflows Security deposit 0 -13500 1 -13500 Lease cost 1 to 3 -56000 2.283225 -127861 Refund of Security deposit 3 13500 0.657516 8876 Total -132484 2 Present value of cashoutflow is less in case of lease alternative by $25427 (157911-132484). Company should accept the lease alternative