Reference no: EM133495902

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 15% interest rate with equal payments at the end of each year. Sadik's tax rate is 25%. The equipment falls in the MACRS 3-year class. (The depreciation rates for Year 1 through Year 4 are equal to 0.3333, 0.4445, 0.1481, and 0.0741.)

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 value is $160,000, 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 last 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:

1. What is the cost of owning? Enter your answer as a positive value. Do not round intermediate calculations.

2. What is the cost of leasing? Enter your answer as a positive value. Do not round intermediate calculations.

3. What is the net advantage of leasing? Do not round intermediate calculations.

4. Should Sadik take the lease? Explain.

5. Since the cost of leasing the machinery is -Select-less greater Item 4 than the cost of owning it, the firm should -Select-lease buy Item 5 the equipment.

6. Consider the $160,000 estimated residual value. How high could the residual value get before the net advantage of leasing falls to zero? Do not round intermediate calculations.