Question

Lease versus borrow to purchase
It is time for the renewal of existing photocopying equipment at Runt Ltd. The current

equipment is worth $14,500. New equipment will cost $135,000.

The $120,000 can be borrowed from the local bank at 5 percent interest with annual payments at the end of each of five years. The CCA rate on the equipment would be 20 percent. The equipment will be salvaged in 5 years for $30,000. An annual maintenance expense of $2,000 would be required at each year end if they purchase the equipment (but not if they lease).

Runt could also lease the equipment with annual lease payments of $27,500 payable at the beginning of each year. Tax savings are at year end.

The cost of capital is 10 percent and the tax rate is 25 percent.
Should Runt Ltd. lease or borrow to purchase the photocopying equipment?

Answer 1

The initial cash flow for new equipment = 135,000 -120,000 (loan) = 15,000

The annual payment for the loan =PMT(rate,nper,pv) =PMT(0.05,5,120000) = 27,716.98

Year	0	1	2	3	4	5
Initial cost	15000
Loan payment to bank		27716.98	27716.98	27716.98	27716.98	27716.98
Depreciation		27000	27000	27000	27000	27000
Maintenance		2000	2000	2000	2000	2000
Salvage value						-30000
Tax savings		-14179.2	-14179.2	-14179.2	-14179.2	-6679.25
After tax cost		42537.74	42537.74	42537.74	42537.74	20037.74
Subtract depreciation:non cash		-27000	-27000	-27000	-27000	-27000
Net Cost	15000	15537.74	15537.74	15537.74	15537.74	-6962.27
Net present cost at 10%	$ 59,929.51

Net present cost of purchase = 59,929

Now, we consider the leases:

Year	0	1	2	3	4	5
Lease payments	27500	27500	27500	27500	27500
tax savings		-6875	-6875	-6875	-6875	-6875
Cost of leasing	27500	20625	20625	20625	20625	-6875
Net present cost of leasing at 10%	$ 88,609.64

The Net present cost of leasing is 88,609.64

Since purchasing has a lower net present cost, it is recommended to borrow to purchase the photocopying equipment rather than to lease it