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A company is considering the possibility of acquiring new manufacturing unit for $6,000,000 cash. The scrap...

A company is considering the possibility of acquiring new manufacturing unit for $6,000,000 cash. The scrap value is estimated to be $500,000 at the end of the 10-year life of the equipment. The firm could lease the equipment for $1,000,000 per year, payable at the start of each year. The equipment will be returned to the lessor at the expiry of the lease. If the firm can earn 15% pa on its capital, advise whether it should buy or lease.

Solutions

Expert Solution

We shall compare present value of both options

1. Lease option

Year PVF @15% Lease payment PV
1 1          1,000,000.00    1,000,000.00
2 0.8695652          1,000,000.00        869,565.22
3 0.7561437          1,000,000.00        756,143.67
4 0.6575162          1,000,000.00        657,516.23
5 0.5717532          1,000,000.00        571,753.25
6 0.4971767          1,000,000.00        497,176.74
7 0.4323276          1,000,000.00        432,327.60
8 0.375937          1,000,000.00        375,937.04
9 0.3269018          1,000,000.00        326,901.77
10 0.2842624          1,000,000.00        284,262.41
TOTAL    5,771,583.92


2. Cash option

PV = CASH PAID - PV of scrap value at end of life

PV = $6,000,000 - $500,000 * PVF(15%, 10 years) = $5,876,407.65

Since PV of lease payments is less so it should lease.

jeff jeffy answered 3 years ago
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