Blinko Products wants an airplane for use by its corporate staff. The airplane that the company wishes to acquire, a Zephyr II, can be either purchased or leased from the manufacturer. The company has made the following evaluation of the two alternatives:
Purchase alternative. If the Zephyr II is purchased, then the costs incurred by the company would be as follows:
Purchase cost of the plane . . . . . . . . . . . . . . . . . . . . . $850,000
Annual cost of servicing, licenses, and taxes. . . . . . . . $9,000
Repairs:
First three years, per year . . . . . . . . . . . . . . . . . . . . . . . $3,000
Fourth year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000
Fifth year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000
The plane would be sold after five years. Based on current resale values, the company would be able to sell it for about one-half of its original cost at the end of the five-year period.
Lease alternative. If the Zephyr II is leased, then the company would have to make an immediate deposit of $50,000 to cover any damage during use. The lease would run for five years, at the end of which time the deposit would be refunded. The lease would require an annual rental payment of $200,000 (the first payment is due at the end of Year 1). As part of this lease cost, the manufacturer would provide all servicing and repairs, license the plane, and pay all taxes. At the end of the five-year period, the plane would revert to the manufacturer, as owner. Blinko Products’ required rate of return is 18%.
Required:
(Ignore income taxes.)
1. Use the total-cost approach to determine the present value of the cash flows associated with each alternative.
2. Which alternative would you recommend that the company accept? Why?