Question

Your firm has just sold non-strategic assets to raise cash for capital investment while avoiding the use of debt. The firm may buy a piece of machinery for $140,000 [with a useful or depreciable life of 4 years]. Your pretax cost of capital is 8% [and your tax rate is 20%]. You can lease the machine for $43,500 per year and the estimated salvage/recovery value at the end of four years [based on actual market data] is $20,000. Should you lease or buy? Explain by showing your work.

Answer 1

Cash outflow in Buying Machinery Initially = $140,000

Depreciation on Machinery per year = ($ 140,000 - $20,000 )/4 = $30,000

Tax Saving @20% on Depreciation each year = $30,000*20 = $6,000

Present value of Tax Saving = $1400 * pv factor of 8% for (1-4years) - $6000 * 3.312 =$19872

Present value of Salavage value of machine = $20,000* Pv factor of 8% for year 4 = $20,000*0.735 = $14700

Cash Outflow = $ 140,000 - ($ 19872 + $14,700) = $1,05,428

ON LEASE OF MACHINE

Lease rent to Pay each year upto 4 year = $43,500

Pv factor at 8% for 1 to 4 year = 3.312

Present value of Lease rent payable = $43,500*3.312 = $144,072

Cash Out flow on LEASE = $144,072

Conclusion ;- BUY option should be choose.