Question

Challenging Problem 5

19-5 Lease versus buy

Sadik industries must install $1 million of new machinery in its Texas plant. It can obtain a 6-year bank loan for 100% of the cost at a 14% interest rate with equal payments at the end of each year. Sadik’s tax rate is 34%. The equipment falls in the MACRS 3-year class.

Alternatively, a Texas investment banking firm that represents a group of investors can arrange a guideline lease calling for payments of $320,000 at the end of each year for 3 years. Under the proposed lease terms, the Sadik must pay for insurance, property taxes, and maintenance.

Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms, it can purchase the machinery at its fair market value at Year 3. The best estimate of this market vale is $200,000, but it could be much higher or lower under certain circumstances. If purchased at Year 3, the used equipment would fall into the MACRS 3- year class. Sadik would actually be able to make the purchase on the least day of the year (i.e., slightly before Year 3), so Sadik would get to take the first depreciation expense at Year 3 (the remaining depreciation expenses would be from Year 4 through Year 6). On the time line, Sadik would show the cost of purchasing the used equipment at Year 3 and its depreciation expenses starting at Year 3.

To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:

a. What is the net advantage of leasing? Should Sadik take the lease?

b. Consider the $200,000 estimated residual value. How high could the residual value get before the net advantage of leasing falls to zero?

Answer 1