Question

C.T. All Ltd., a manufacturer of customized baseball souvenirs, is negotiating with the Grand Slam Company to purchase or to lease a machine that produces foam cushions for seating at baseball parks. The machine would cost $250,000. In five years the machine would have an estimated salvage value of $40,000. Its useful economic life is nine years. These machines have a CCA rate of 20 percent.

C.T. All can borrow funds at 13 1/3 percent from its Nearby Bank, and has a tax rate of 25 percent. The capital cost rate on this machine is 9 percent, and C.T. All’s cost of capital is 15 percent. Lease payments would be at the beginning of each year, and tax savings would occur at the end of each year. Lease payments would be $64,645.

We note that of all the cash flows, the salvage value has the greatest uncertainty. We recognize this by discounting the salvage value at a higher discount rate—the cost of capital.

a-1. Calculate PV cost of lease alternative. (Do not round the intermediate calculations. Round the final answer to nearest whole dollar. Input the answer as positive value.)

PV cost           $

a-2. Calculate PV cost of borrowing/purchase alternative. (Do not round the intermediate calculations. Round the final answer to nearest whole dollar. Input the answer as positive value.)

PV cost           $

b. Should C.T. All Ltd. lease or borrow to purchase the machine?

• Lease

• Borrow/Purchase

Answer 1

a-1 : PV of the lease option

Formulae (a -1)

a-2: PV of the Borrow/Purchase option:

Formulae for a-2

Answer a -3 CT All should purchase the machine as the PV of the costs are lesser.

The purchase option is selecetd as there is a salvage value of the equipment, which offers more benefit in present value terms. If there is no salvage cash flow, then the operating lease becomes the better economic decision.

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