Question

Carolina will have to replace few trucks in its fleet at the end of this year. Carolina can lease trucks or buy them today with cash. Lease will require monthly lease payments of $12,000 at the beginning of each month for the next 5 years. Alternatively, Carolina can buy trucks today for $625,000 with available cash. If the opportunity cost of funds is 6.0% per year, should Carolina buy or lease? (Ignore taxes, service costs, down payment, fees on the lease etc. Hint: two options can be compared from cost perspective).

Answer 1

Pmt = 12000; N = 60 months (5 years x 12); Rate = 6%

As payment is made at beginning of each month below formula of Present value (PV) should be applied:

PV of lease payment = Pmt + Pmt x ((1 – (1+ Rate/12)^-(N-1)) / (Rate/12))

PV of lease payment = 12000 + 12000 x ((1 - (1+ 6%/12)^-(60-1)) / (6%/12))

PV of lease payment = $623,810.26

As present payment to buy a Truck is $625,000 which is more than present value of lease payment which is calculated to be $623,810.26

$625,000 > $623,810.26 it is not advisable to buy truck.

Hence, we should go for “Lease” as buying is expensive.