Question

Question # 06                                                                                                                  [10 marks]
Roberts Company, a small machine shop, is contemplating acquiring a new machine that costs $24,000. Arrangements can be made to lease or purchase the machine. The firm is in the 40% tax bracket. The firm would obtain a 5-year lease requiring annual end-of-year lease payments of $6,000. All maintenance costs would be paid by the lessor, and insurance and other costs would be borne by the lessee. The lessee would exercise its option to purchase the machine for $1,200 at termination of the lease.  
The firm would finance the purchase of the machine with a 9%, 5-year loan requiring end-of-year installment payments of $6,170. The machine would be depreciated by 20% in year 1, 32% in year 2, 19% in year 3, and 12% in years 4 and 5. The firm would pay $1,500 per year for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm. The firm plans to keep the machine and use it beyond its 5-year recovery period.

i. Find the after-tax cash outflows for each year under the lease alternative.
ii. Find the after-tax cash outflows for each year under the purchase alternative.
iii. Calculate the present value of the cash outflows associated with the lease and purchase alternatives using the after-tax cost of debt as the discount rate.
iv. Choose the alternative with the lower present value of cash outflows from Step 3. It will be the least-cost financing alternative.

Answer 1