With the big boom of the telecommunications industry within recent years, many telecom companies are looking for ways to expand their base and grab that incremental part of market share. The advancement of technology causes a greater consumer demand to fulfill the voids of older, less effective communication methods. Technology and growth are the means by which the telecom industry has been able to boom. Riverbend Telephone Company is one of those telecom organizations that is looking to broaden their market share in the telecom industry.
Riverbend Telephone Company is an independently owned telecom organization. It’s current market base is local but the challenge is to broaden its geographic coverage area. Customers in this local, and nearby, communities are able to receive telephone service from Riverbend. Recently, this geographic area has undergone aggressive growth. This growth is attributed to the construction of a new bridge between two small cities. With more access to this additional city, Riverbend is seeing a need for telephone service in this new area, and thus the opportunity to expand their market.
With the new area that needs to be served, Riverbend evaluated and concluded that it needed at least one new maintenance truck and an additional crew. The need to obtain a new truck presents opportunities for further analysis to determine if the truck should be purchased or leased and if one option is selected over the other, how will this decision affect future costs to Riverbend? 1) Should Riverbend buy or lease the truck? In order to do a fair comparison of number, we need to calculate the present value of an annuity for leasing the vehicle.
With an assumed discount rate of 10%, over the course of 5 years, we calculated a present value of $27,293. 76. So if we were to look at price alone, the present value for leasing a vehicle for 5 years at $7,200 a year would be $27,293. 76 which is $2,993. 76 more than if the company would purchase the car outright for $24,300.
Although the total net present value increases using the double-declining balance method, it is still lower than the option to leasing the vehicle.
If the truck is leased, how should Mr. Freeman report investment and annual income for the Riverbend Telephone Company to the State Public Service Commission? In reporting its rate of return on assets, since the present value of the lease payments is greater than 90% of the fair market value ($27,293 vs $24,300 FMV) as shown earlier, it would be considered a capital lease and the asset would go on the balance sheet. There are no earnings over asset ratio advantages to leasing as the net assets or denominator is the same in both cases. The value of the truck should be included in the firm’s net assets.
Their income is affected by the $7,200 a year being an expense and subtracted from their revenues thus decreasing their income. However, as stated earlier, there are tax savings associated with leasing since the expense is subtracted from the income to be taxed. In conclusion, the obvious choice as depicted in all the analysis that we did for the case study shows that Riverbend should purchase the vehicle as oppose to leasing the vehicle. There were many determinants which affected our decision but the most important determinant was the net present value of the total expenses at the end of the 5 years. Bottom line, purchasing the truck was the least expensive means of obtaining the necessary equipment needed to facilitate the growth of the company.
Riverbend would end up saving thousands of dollars in the end by purchasing the truck instead of leasing it. However, if we took one step further and looked into opportunity costs associated with leasing vs. purchasing, our decision may have come out different. For instance, if Riverbend decided to lease the truck so that they could have some free cash to invest in other things like advertisement that could potentially bring in more revenue in an amount greater than the money saved by purchasing the truck outright, then obviously they should lease it to free up the cash. However, it is very hard to predict opportunity costs so the most conservative choice would be to purchase the truck.
