Question

Kiddy Toy Corporation needs to acquire the use of a machine to be used in its manufacturing process. The machine needed is manufactured by Lollie Corp. The machine can be used for 10 years and then sold for $22,000 at the end of its useful life. Lollie has presented Kiddy with the following options: (FV of $1, PV of $1, FVA of $1, PVA of $1, FVAD of $1 and PVAD of $1) (Use appropriate factor(s) from the tables provided.) 1.Buy machine. The machine could be purchased for $172,000 in cash. All maintenance and insurance costs, which approximate $17,000 per year, would be paid by Kiddy. 2.Lease machine. The machine could be leased for a 10-year period for an annual lease payment of $37,000 with the first payment due immediately. All maintenance and insurance costs will be paid for by the Lollie Corp. and the machine will revert back to Lollie at the end of the 10-year period. Required: Assuming that a 10% interest rate properly reflects the time value of money in this situation and that all maintenance and insurance costs are paid at the end of each year, find the present value for the following options. Ignore income tax considerations. Determine which option Kiddy should choose. (Negative amounts should be indicated by a minus sign. Round your final answers to nearest whole dollar amount.)

Answer 1

Decision - To Lease the machine based on the following calculation.

Calculation of present value of cash outflow for machine.

1) Buy machine

Purchase cost = $ 172,000. It is to be purchased today. So, its present value will be $ 172,000

Maintenance cost = $ 17,000. ITs present value is,

= 17,000 * 6.14456 (1/1.10^10)

= $ 104,457

Salvage Value = $ 22,000 at the end of 10th year. so, its present value will be:-

= $ 22,000 * 0.3855 (for $1 at 10th year @ 10%)

= $ 8,481

So, PV of cash outflow for purchase option = 172,000 + 104,457 - 8,481

= $ 267,976

2) Lease option

Present value of lease rental

= 37,000 (First payment due today) + 37,000 * 5.7588 (1/1.10^9)

= 37,000 + 213,076

= 250,076

So, if we buy the machine insted of lease, we end up paying $ 17,900 more.

So, we recommend to lease the machine insted of buying the machine.

Note :- Here, we are asked not to consider the tax consideration. However, if we consider the tax consideration, we should buy the machine because we can get the benefit of depreciation on that.