Parcels Delivered Quickly (PDQ) is a public company that provides shipping and delivery services for household and commercial parcels ranging from a few grams to several hundred kilograms. The company uses a fleet of 800 trucks and vans to pick up and deliver parcels. For inter-city shipping, the company has an arrangement with commercial airlines to ship parcels using airlines’ cargo capacity.

The volume of parcel shipments has been increasing steadily since the start of online shopping in the late 1990s, as consumers search for the best deals regardless of physical location. As a result, PDQ needs to expand its fleet capacity by 200 vehicles to meet the increasing demand. In addition, 200 of the existing vehicles will need to be replaced over the next two years as they come to the end of their service lives. 

Management is concerned about the potential for adverse reactions from investors should the company’s leverage become too high or if profitability suffers as a result of this program to replace and expand the vehicle fleet. As a result, instead of borrowing and buying the needed vehicles outright, PDQ’s management is considering two other alternatives:

Option 1: Lease the trucks and vans with short-term leases, one year at a time and elect to expense these short-term leases. For a truck with a cost of $80,000, the annual lease payment would amount to $15,000, due in advance. 

Option 2: Lease the vehicles with long-term leases that last for the 10 years of the expected useful life. For a truck with a cost of $80,000, the annual payments would be $11,000. These leases would transfer title to PDQ at the end of the lease. 

With either option, PDQ would be responsible for maintenance and repairs on the vehicles. 

PDQ currently has about $32 million in total assets and $19 million in liabilities. Debt on the balance sheet carries an average interest rate of 7%. The company’s bank has quoted a 9% interest rate for additional borrowing.

Required:

Analyze the alternatives relevant to the fleet replacement and expansion and provide your recommendation to management for the best course of action. Assume that PDQ depreciates vehicles using the declining-balance method at a 20%. rate.