Question

PLEASE SHOW WORKINGS ON EXCEL

FM Corporation is considering either purchasing or leasing an asset that costs $1,000,000. The asset, if purchased, will be depreciated on a straight-line basis over six years to a zero residual value. Ace Leasing company is willing to lease the asset for $300,000 per year; the first payment on the lease is due at the time the lease is undertaken (i.e., year 0), and the remaining five payments are due at the beginning of years 1–5. Your company has a tax rate of 40 percent and can borrow at 10 percent from its bank.

(a) Recommend if your company should lease or purchase the asset?

(b) Compute the maximum lease payment FM Corporation would agree to pay?

Answer 1

Answer (A)

OPTION 1: PURCHASE OF MACHINE

PRESENT VALUE OF OUTFLOW ON PURCHASE OF MACHINERY = $1,000,000

Therefore in Option 1

Present Value of Net outflow = Purchase Price - Present value of Savings in Tax due to Depreciation

= 1,000,000-287,734.94    

= $ 712,265.06      

OPTION 2: LEASING OF MACHINE

Since in Purchase option Present Value of Net outflow is low therefore it is beneficial for company to purchase the Asset.

Answer (B)

Maximum Lease Payment = NET OUTFLOW IN PURCHASE OPTION / P.V. ANNUITY FACTOR AT 10%

                                      = $ 712,265.06 / 1+.09091+.8264+.7513+.6830+.6209    

                                      = $ 712,265.06 / 3.97251

                                    = $ 179,298.49