The Wrongway 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 companys 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 as follows:

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 $18,300 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	$	6,450
Repairs, year 1		1,850
Repairs, year 2		4,150
Repairs, year 3		6,300

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 $57,750 per year (with 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. Wrongway would be required to make a $21,250 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.

Wrongways required rate of return is 18%.

Click here to view Exhibit 10-1 and Exhibit 10-2, to determine the appropriate discount factor(s) using tables.

Required:
(Ignore income taxes.)
1.	Use the total cost approach to determine the present value of the cash flows associated with each alternative. (Negative amounts should be indicated with a minus sign. Round discount factor(s) to 3 decimal places. Round other intermediate calculations and final answers to the nearest whole dollar amounts.) what is the purchase value of cash flows for the purchase of fleet and lease of cars?

Expert Answer

• sucess2all answered this

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  Purchase Alternative

  Cash Flow

  Year 0 = Purchase cost

  Year 0 = - 18300*10

  Year 0 = -183000

  Year 1 = - Annual cost of servicing, taxes, and licensing - Repair Cost

  Year 1 = -6450-1850

  Year 1 = -8300

  Year 2 = - Annual cost of servicing, taxes, and licensing - Repair Cost

  Year 2= -6450-4150

  Year 2 = -10600

  Year 3 = - Annual cost of servicing, taxes, and licensing - Repair Cost + Salvage Value

  Year 3= -6450-6300 + 50%*183000

  Year 3 = 78750

  Present value of the cash flows associated = Year 0 Cash Flow + Year 1 Cash Flow*PVIF(rate,nper) + Year 2 Cash Flow*PVIF(rate,nper) + Year 3 Cash Flow*PVIF(rate,nper)

  Present value of the cash flows associated = -183000 -8300*PVIF(18%,1) -10600*PVIF(18%,2) +78750*PVIF(18%,3)

  Present value of the cash flows associated = -183000 -8300*0.847 -10600*0.718 +78750*0.609

  Present value of the cash flows associated = - $ 149,682

  Lease Alternative

  Cash Flow

  Initial Investment = Security Deposit

  Initial Investment = -21250

  Annual cash outfow = -57750

  Terminal Cash Flow = 21250

  Present value of the cash flows associated =Initial Investment + Annual Cash Flow*PVIFA(rate,nper) + Terminal Cash Flow*PVIF(rate,nper)

  Present value of the cash flows associated = -21250 - 57750*PVIFA(18%,3) + 21250*PVIF(18%,3)

  Present value of the cash flows associated = -21250 - 57750*2.174 + 21250*0.609

  Present value of the cash flows associated = - $ 133,857

  Decision : Select Lease alternative as its Present value of the cash out flows is lower than purchase alternative