Question

Certain manufacturing equipment can be purchased today for $500,000. The expected end-of-year operating cost for the equipment over the next five years is $60,000 per year. The expected end-of-year maintenance cost of the equipment for the same period is $20,000 per year. The salvage value of the equipment at the end of five years of service is expected to be $150,000. As an alternative, the selling company offers to lease the equipment for $150,000 per year (maintenance included) with beginning of years payments. The company considering the purchase uses an opportunity rate of 25% to evaluate expenditures of this type. Determine whether the company should lease or purchase by comparing equivalent annual cost.

Answer 1

In this case, we have beginning of period payments in case of leasing option. So,

Equivalent Annual cost of leasing option=AWL=150000*(1+i)=150000*(1+25%)=$187,500

Now consider the purchase option

Initial value=I=$500,000

Salvage=S=$150,000

Useful life=n=5 years

Discount rate=i=25%

Capital Recovery=CR=(I-S)*(A/P,i,n)+S*i

CR=(500000-150000)*(A/P,0.25,5)+150000*25%

Let us calculate the interest factor

CR=(500000-150000)*0.371847+150000*25%=$167646.45

Equivalent Annual cost of purchase option=AWP=CR+(60000+20000)

AWP=167646.45+(60000+20000)=$247,646.45

Since AWL<AWP, lease option should be preferred.