Question

Memories, Inc. currently leases its equipment from Quality Materials, Inc. for $2,500 per month. Two years of their contracted five-year lease term remain. MI may terminate the lease at any time by paying a penalty of $10,000. They are considering purchasing the equipment from Quality Materials, Inc. to replace the leased equipment. MI must purchase 10 units of each piece of equipment. Memories, Inc. can purchase equipment at the following prices: Equipment Price per unit Heater $ 2,100 Injection molder $ 5,450 Sealer $ 4,100 Cardboard cutter $ 2,695 Label installer $ 1,000 Required: A) Using NPV analysis, compare the present value of the least payments with the cost of buying the equipment. Assume a discount rate of 10 percent (ignore tax.) Which option is preferable? B) MI has the option of purchasing equipment from another supplier at a total cost of $190,000. The supplier promises that the new equipment will reduce operating costs by $1,000 per month over the life of the equipment. Assume a 10 percent discount rate (ignore tax.) Which option is preferable? C) Calculate the after-tax NPV for each option in A and B assuming a 30 percent tax rate. If purchased, all equipment will be depreciated over five years, using straight-line depreciation, and will have no salvage value. Which of the three options is preferable now? (Lease, Purchase from Quality Materials, Purchase for $190,000) D) What factors other than cost savings should MI consider in these decisions?

Answer 1

A
	Lease payment	Discounting factor	PV of Lease Rentals
Yesr 1	30000	0.91	27,272.73
Year 2	30000	0.83	24,793.39
Year 3	30000	0.75	22,539.44
Year 4	30000	0.68	20,490.40
Year 5	30000	0.62	18,627.64
Total cost under lease			1,13,723.60
At the end of third year Memories Inc planning to buy equipment-
Cost of equipments from Quality Materials=	+(2100+5450+4100+2695+1000)*10
	153450
Penalty	10000
Total cost of buying	163450
Discounting factor for third year	0.75
PV OF Total cost of Buying	122587.5
Therefore, in the given case Lease Option is better then Purchase Option.
B
Cost of buying the equipment from other supplier	190000
Less: Reduction in operating cost in next two year	24000
+1000*12*2
Add Penalty for terminating Lease	10000
Total cost	176000
Discounting factor for third year	0.75
PV OF Total cost of Buying	132000
Therefore, given all the three options lease is the best option.
C.
	Lease	Buying from Quality	Buying from other
NPV	113723.6	122587.5	132000
Depreciation		30690	38000
Tax	30%	30%	30%
After Tax NPV	79606.522	85811.25	92400
D. Apart from Cost saving MI should also consider the penalty involved in termination of lease.
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