Britney Spears Company wants a hovercraft for use by its corporate staff. The hovercraft that the company wishes to acquire, a Screamer III, can be either purchased or leased from the manufacturer. The company has made the following evaluation of the two alternatives:
Purchase alternative. If the Screamer III is purchased, then the costs incurred by the company would be as follows:
Purchase cost of the hovercraft.........................................$890,000
Annual cost of servicing, licenses, and taxes...........................$7,000
Repairs:
First three years, per year..................................................$5,000
Fourth year..................................................................$7,000
Fifth year..................................................................$14,000
The hovercraft 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 Screamer III is leased, then the company would have to make an immediate deposit of $64,000 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 $120,000 (the first payment is due at the end of Year 1). As part of this lease cost, the manufacturer would provide all servicing and repairs, license the hovercraft, and pay all taxes. At the end of the five-year period, the hovercraft would revert to the manufacturer, as owner.
Britney Spears Company required rate of return is 10%. (Ignore income taxes.)
Required:
1a. Use the total-cost approach to determine the present value of the cash flows associated with purchase alternative. (Negative amount should be indicated by a minus sign. Round discount factor(s) to 3 decimal places, intermediate and final answers to the nearest dollar amount. Omit the "$" sign in your response.)
1b. Use the total-cost approach to determine the present value of the cash flows associated with lease alternative. (Negative amount should be indicated by a minus sign. Round discount factor(s) to 3 decimal places, intermediate and final answers to the nearest dollar amount. Omit the "$" sign in your response.)
2. Which alternative should the company accept?