Question

15-6. Alumco Industries must install $1 million of new computer equipment in its Ontario plant. It can obtain a bank loan for 100% of the required amount. Alternatively, Alumco believe3ns that it can arrange for a lease financing plan. Assume that these facts apply:

(1) The computer equipment falls into asset Class 45 with a declining balance CCA rate of 45%.

(2) Estimated maintenance expenses are $50,000 per year.

(3) The firm's tax rate is 34%.

(4) If the money is borrowed, the bank loan will be at a rate of 14%.

(5) The tentative lease terms call for payments of $320,000 at the beginning of each year for 3 years. (6) Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.

(7) The best estimate of the market value at the end of 3 years is $200,000, but it could be much higher or lower under certain circumstances. To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:

(a) Should the firm lease or borrow and buy the equipment? Explain.

(b) Consider the $200,000 estimated residual value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows—are they all equally risky?

Answer 1

a.Lease or Buy

Aulmco industries should opt for lease because effective cost incase of lease is 244200$ whereas effective cost incase of purchase is 422400$

Notes:

1.It is assumed that lease is operating lease

2. It is assumed that CCA rate of 45% is determined after adjusting residual value of 200000$

b.The residual value, also known as salvage value, is the estimated value of a fixed asset at the end of its lease term or useful life. In lease situations, the lessor uses residual value as one of its primary methods for determining how much the lessee pays in periodic lease payments. As a general rule, the longer the useful life or lease period of an asset, the lower its residual value.

therefore if asset life is longer then the risk of realizing residual value will be higher accordingly company should discount with some other rate (more risker than normal cash flows) and if asset life is less then company can discount it with same rate as other cash flow.