Question

The management of The Alexandrov Company decided to acquire the use of a machine to be used in its manufacturing process. The machine is manufactured only by Chang, Incorporated and would have a useful life of ten years. Chang’s management has presented Alexandrov with the following acquisition options:

Lease: The machine could be leased for an eight-year period for an annual lease payment of $60,000, with the first payment due on the date that the agreement is signed. Related annual executory costs (maintenance and insurance expenses for the machine), which are expected to be about $5,000 per year, would be paid by Alexandrov.

Purchase: The machine could be purchased for $375,000 in cash.

Assume that (1) Alexandrov and Chang will agree on a transaction on November 30, 2020; and (2) the current interest rate for Alexandrov’s lease arrangements is 9%, but the rate applicable to annual maintenance and insurance expenses is only 6%.

Using the accompanying Time Value of Money tables, prepare a schedule showing the alternatives available to Alexandrov for the acquisition of the machine.

Answer 1

Schedule showing alternatives available to Alexandrov for the acquisition of machine:

Lease option:

Date of entering into agreement = Nov 30, 2020

Lease Term = 8 Years

Annual lease payments = $60,000 with first payment to be made on the date of agreement

Current interest rate for lease arrangements = 9%

Annual executory costs = $5,000 per annum

Rate applicable to executory costs = 6%

Calculation of present value of Annual lease payments and executory costs:

Year	Annual lease payments (1)	PVF@9% (2)	Present value of Annual lease payments (1)×(2)	Annual Executory costs (3)	PVF@6% (4)	Present value of Executory costs (3)×(4)
0	60,000	1	60,000	-	-	-
1	60,000	0.9174	55,044	5,000	0.9434	4,717
2	60,000	0.8417	50,502	5,000	0.8900	4,450
3	60,000	0.7722	46,332	5,000	0.8396	4,198
4	60,000	0.7084	42,504	5,000	0.7921	3,960.5
5	60,000	0.6499	38,994	5,000	0.7473	3,736.5
6	60,000	0.5963	35,778	5,000	0.7050	3,525
7	60,000	0.5470	32,820	5,000	0.6651	3,325.5
8	-	-	-	5,000	0.6274	3,137
Total			3,61,974			31,049.5

Total present value of Annual lease payments and Annual Executory costs = 3,61,974+31,049.5 = $3,93,023.5

Purchase Option:

Purchase of Machine at a cash price of $3,75,000

Summary:

Cash outflows under Lease Option = $3,93,023.5

Cash outflows under Purchase Option = $3,75,000

Conclusion: As Cash outflow under purchase option is lower, it is better to purchase the machine rather than leasing it.