Reference no: EM132869094

Introduction

Lease versus buy decisions abound in the aviation industry. Examples include whether to lease or buy an aircraft or machinery. The evaluation process is similar regardless of the purpose and focuses on analyzing the cash flows associated with each decision. The total cash flows are examined on an after-tax basis and converted to their present value. If the present value of the purchase decision is higher than the leasing decision, the company should purchase versus lease. If the present value of the lease decision exceeds that of the purchase decision, the company should lease. Often maintenance costs are born by the lessor which may make the leasing decision more favorable to the company. Tax considerations are important as well because the owner of the equipment can depreciate the asset, while the lessor cannot.

Instructions

The problem below allows you to demonstrate your understanding of these concepts.

Fly Away Corporation makes pumps for the aviation industry. They are contemplating buying a new machine that costs $25,000. Arrangements can be made to lease or purchase the machine. The firm is in the 40% tax bracket.

Lease: If they lease, the firm would obtain a 5-year lease requiring annual end-of-year lease payments of $5,000. All maintenance costs would be paid by the lessor. The lessee would exercise its option to purchase the machine for $1,200 at termination of the lease.

Purchase: The firm would finance the purchase of the machine with a 7%, 5-year loan requiring end-of-year installment payments of $6,097. The machine would be depreciated under MACRS using a 5-year recovery period (20% in year 1, 32% in year 2, 19% in year 3, 12% in years 4 and 5). The firm would pay $1,500 per year for a service contract that covers all maintenance costs; insurance and other costs would be borne by the firm. The firm plans to keep the machine and use it beyond its 5-year recover period. The interest payments and depreciation provide a tax shield to the owner.

Problem 1: Determine if Fly Away Corporation should lease or purchase the machine and why. You can use an Excel spreadsheet or calculator to help. Make sure that whatever you use, you keep track of *all your work and turn that in with your answer. Providing all of your work will make it easier to explain your answer. *Be sure to discount cash flows at a 6% discount rate.