Q: Management has decided to acquire a new asset that costs $200,000. The estimated economic life of the asset is five years, but the firm wants the use of the asset only for three years. If the firm purchases the asset, it anticipates selling it at the end of three years for $50,000.
The firm may lease the asset for $55,000 a year paid at the end of each year. The lease does not include maintenance. It is estimated that annual maintenance initially will be $5,000 (paid at the end of the year), but that cost will increase by $1,000 each year as the asset ages.
The firm could purchase the asset with a fiveyear loan of $200,000. The loan will be retired in five payments of $40,000 unless the equipment is sold, in which case the loan must be paid off at closing of the sale. The interest rate is 10 percent and is paid at the end of each year on the balance owed. The annual interest payment is provided below.
If the firm does purchase the asset, it will enter into a maintenance agreement with the manufacturer that costs $5,000 a year. The annual depreciation expense is provided below. The firm’s tax bracket is 40 percent.
Based on the above information, should the firm borrow and purchase or should the firm lease?
To help answer the question, fill in the following tables. (It is not necessary to have an entry in every blank.)
Cash Outflows/Inflows Associated with Leasing
Year 12345 Lease payments
Maintenance
Total taxdeductible expenses
Tax savings
Aftertax net cash outflow from leasing
Cash Outflows/Inflows Associated with Owning
Year 12345 Maintenance
Depreciation
Interest
Principal Repayment
Total taxdeductible expences
Tax savings
Sale of equipment
Aftertax inflow from sale of equipment
Aftertax net cash outflow from owning
Answer
Since the present value of the cash outflows from owning exceed the present value of the cash outflows from leasing, leasing is preferred.
Cash Outflows/Inflows Associated with Leasing
Year 123
40,000...