Question

1. O’Brien, Inc. needs a stamping machine for their factory so they can better meet customers’ requirements. After investigating numerous alternatives they have the following alternatives:
2. Purchase Machine A for $120,000.
3. Lease Machine B, a similar machine, for 7 years (8 year EUL) for $20,000 at the beginning of each year. There is no transfer of ownership or bargain purchase option. There is no salvage value at the end of the lease term. O’Brien’s incremental borrowing rate is 9%.
4. Use Excel to prepare a lease amortization schedule and a depreciation schedule for the term of the lease. Prepare journal entries for the inception of the lease and the first three lease payments and first three depreciation entries. Should O’Brien purchase Machine A or lease Machine B? Why?

Answer 1

Present value of the future lease payments = Lease payments * Present value of annuity due ( 9%, 7years) = 5.48592 * 20,000 = 109718.4

Year	Lease payments	Interest on lease liability [PV of lease *9%]	Reduction of lease liability [Lease - Interest]	Lease liability [ Pv of previous year - Principal]
Inception				109718.4
1	20,000	0	20,000	89,718
2	20,000	8074.656	11,925	77,793
3	20,000	7001.37504	12,999	64,794
4	20,000	5831.498794	14,169	50,626
5	20,000	4556.333685	15,444	35,182
6	20,000	3166.403717	16,834	18,349
7	20,000	1651.380051	18,349	0

Date	Account Titles	Debit	Credit
Year 1	Leased equipment	109718
	Obligation under capital lease		109718
Year 1	Obligation under capital lease	20,000
	Cash		20,000
Year 1	Depreciation expense [109718/7]	15674
	Accumulated depreciation - capital leases		15674
Year 2	Obligation under capital lease	11,925
	Interest payable	8075
	Cash		20,000
Year 2	Depreciation expense [109718/7]	15674
	Accumulated depreciation - capital leases		15674
Year 3	Obligation under capital lease	12,999
	Interest payable	7001
	Cash		20,000
Year 3	Depreciation expense [109718/7]	15674
	Accumulated depreciation - capital leases		15674

The company should lease the machine since the present worth of cash outflows is lesser as compared to purchasing the machine.