Question

A company has the option of leasing equipment for an annual fee of £3500 over four years or buying it for £12 500. If the equipment is worthless at the end of four years, which option is preferable if the annual rate of interest is (a) 5%, and (b) 4%?

Answer 1

(a)

The company can either lease the equipment for an annual fee of 3500 pounds over four years or can buy it for 12,500 pounds.

If company purchases the equipment, it will pay 12,500 pounds now.

So,

The present value of purchasing the equipment is 12,500 pounds.

The interest rate is 5%.

Calculate the present value of the annual lease -

Present value of the annual lease = Annual lease (P/A, i, n)

Present value of the annual lease = 3,500(P/A, 5%, 4) = 3,500 * 3.5460 = 12,411

The present value of the annual lease is 12,411 pounds.

It can be seen that the present value of the annual lease is less than the present value of purchasing the equipment.

This means it would be cost effective for the company to lease the equipment.

Thus,

The preferrable option is to lease the equipment for four years.

(b)

The company can either lease the equipment for an annual fee of 3500 pounds over four years or can buy it for 12,500 pounds.

If company purchases the equipment, it will pay 12,500 pounds now.

So,

The present value of purchasing the equipment is 12,500 pounds.

The interest rate is 4%.

Calculate the present value of the annual lease -

Present value of the annual lease = Annual lease (P/A, i, n)

Present value of the annual lease = 3,500(P/A, 4%, 4) = 3,500 * 3.6299 = 12,704.65

The present value of the annual lease is 12,704.65 pounds.

It can be seen that the present value of the annual lease is greater than the present value of purchasing the equipment.

This means it would be cost effective for the company to purchase the equipment.

Thus,

The preferrable option is to purchase the equipment now.