In: Accounting
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. The machine would have a useful life of ten years and would then be sold for $10,000 at the end of its useful life. 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 $25,000, 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 $130,000 in cash. The related maintenance and insurance costs would also become the additional responsibility of Alexandrov.
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 12%, but the rate applicable to annual maintenance and insurance expenses is only 8%.
Prepare a schedule showing the alternatives available to The Alexandrov Company for the acquisition of the equipment.
Answer :
Present value of cash outflow - Lease
Year | Lease payment | Annual maintenance and insurance | PVF12% | PVF 8% | Present value of cash outflow |
(1) | (2) | (3) | (4) | (5) | (2)*(4) + (3)*(5) |
1 | $25,000.00 | $5,000.00 | 1.0000 | 1.0000 | $30,000.0000 |
2 | $25,000.00 | $5,000.00 | 0.8929 | 0.9259 | $26,951.0582 |
3 | $25,000.00 | $5,000.00 | 0.7972 | 0.8573 | $24,216.5410 |
4 | $25,000.00 | $5,000.00 | 0.7118 | 0.7938 | $21,763.6674 |
5 | $25,000.00 | $5,000.00 | 0.6355 | 0.7350 | $19,563.1012 |
6 | $25,000.00 | $5,000.00 | 0.5674 | 0.6806 | $17,588.5874 |
7 | $25,000.00 | $5,000.00 | 0.5066 | 0.6302 | $15,816.6262 |
8 | $25,000.00 | $5,000.00 | 0.4523 | 0.5835 | $14,226.1824 |
Total | $170,125.7638 |
Present vlaue of cash outflow - purchase
Year | Initial investment and salvage value | Annual maintence and insurance | PVF 8% | PVF 8% | Present value of cash outflow |
(1) | (2) | (3) | (4) | (5) | (2)*(4) + (3)*(5) |
1 | $130,000.00 | $5,000.00 | 1.0000 | 1.0000 | $135,000.0000 |
2 | $ - | $5,000.00 | 0.9259 | 0.9259 | $4,629.6296 |
3 | $ - | $5,000.00 | 0.8573 | 0.8573 | $4,286.6941 |
4 | $ - | $5,000.00 | 0.7938 | 0.7938 | $3,969.1612 |
5 | $ - | $5,000.00 | 0.7350 | 0.7350 | $3,675.1493 |
6 | $ - | $5,000.00 | 0.6806 | 0.6806 | $3,402.9160 |
7 | $ - | $5,000.00 | 0.6302 | 0.6302 | $3,150.8481 |
8 | $ - | $5,000.00 | 0.5835 | 0.5835 | $2,917.4520 |
9 | $ - | $5,000.00 | 0.5403 | 0.5403 | $2,701.3444 |
10 | $ (10,000.00) | $5,000.00 | 0.5002 | 0.5002 | $(2,501.2448) |
Total | $161,231.9499 |
If machine is purchaed, there are two benefits. Firstly it has the lower cash outflow. Secondly, it can be used for 10 years while lease term is just 8 years. And hence, putchase of machinery is recommended.
Notes :