Company ABC Inc has just sold an asset for $2.3 million for the purpose of self-financing...

Company ABC Inc has just sold an asset for $2.3 million for the purpose of self-financing a capital expansion program that may include purchase of a piece of manufacturing equipment for $1.6 million. The company’s tax rate is 25%, its required rate of return is 11%, the estimated salvage or recovery value of the equipment at the end of 3 years is $450,000. Given the high-tech nature of its industry, the conservative approach is to use a depreciable life of 3 years on a straight line basis. The alternative is to lease the same piece of equipment for $425,000 over the same period. Should ABC lease or buy? Show your work to justify your decision or recommendation.

Expert Solution

Lease alternative has higher NPV. Hence lease the asset.

	Lease
Year	Cash flows
0
1	-318750
2	-318750
3	-318750

NPV	($778,934.07)

Buy
Year	Initial cost	Tax shield	Salvage	Net cash flows
0	-1,600,000			-1,600,000
1		133333.3		133,333
2		133333.3		133,333
3		133333.3	337500	470,833

			NPV	($1,027,394.28)

WORKINGS

jeff jeffy answered 6 months ago

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