Reference no: EM132515670

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 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 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 $23,800 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 $5,200

Repairs, year 1 2,050

Repairs, year 2 5,625

Repairs, year 3 6,800

• 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 $75,500 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 $23,500 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.
• Wrongway's required rate of return is 18%.

REQUIRED:

(Ignore income taxes.)

Question 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.)

Question 2. Which alternative should the company accept based on the calculations in part (1)?

• Purchase of fleet or lease of cars?