24.07.2022 - 11:55

# 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 compa

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 $18,000 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$3,400 Repairs, first year $1,300 Repairs, second year$3,800 Repairs, third year $5,800 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$53,000 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 $12,000 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 14%. Required: 1. Use the total-cost approach to determine the present value of the cash flows associated with each alternative. (Round discount factor(s) to 3 decimal places) 2. Which alternative should the company accept? Answers (1) • April 4, 2023 в 08:15 1. To use the total-cost approach, we need to calculate the present value of cash flows for each alternative. For the purchase alternative: Year 0: -$180,000 (purchase cost) Year 1: -$3,400 -$1,300 (annual servicing cost and repairs) = -$4,700 Year 2: -$3,400 - $3,800 (annual servicing cost and repairs) = -$7,200 Year 3: -$3,400 -$5,800 (annual servicing cost and repairs) + $90,000 (sale of fleet) =$80,800 Discount factor at 14%: Year 0: 1.000 Year 1: 0.877 Year 2: 0.769 Year 3: 0.675 Present value of cash flows: -$180,000 + (-$4,124.90) + (-$5,531.28) +$54,522 = $35,865.82 For the lease alternative: Year 0: -$12,000 (security deposit) Year 1: -$53,000 Year 2: -$53,000 Year 3: -$53,000 +$12,000 (refund of security deposit) = -$41,000 Discount factor at 14%: Year 0: 1.000 Year 1: 0.877 Year 2: 0.769 Year 3: 0.675 Present value of cash flows: -$12,000 + (-$46,461) + (-$40,701) + $27,540 = -$71,622 2. Based on the total-cost approach and present value of cash flows, the company should choose the purchase alternative since it has a lower present value of cash flows compared to the lease alternative. The purchase alternative has a present value of $35,865.82, while the lease alternative has a present value of -$71,622.