Reference no: EM132939873

Question - GOODWEALTH Inc., is considering whether it should lease or purchase a machine. The machine costs $300,000. If GOODWEALTH buys the machine, it will be depreciated straight-line to zero in years 1, 2 and 3. GOODWEALTH can then sell the machine for $50,000 in year 3. In order to use the machine, GOODWEALTH has to bear a maintenance cost of $10,000 in years 1, 2 and 3. The tax rate for GOODWEALTH is 30%. The (pre-tax) cost of debt for GOODWEALTH is 10%. Alternatively, GOODWEALTH can lease the machine by making 3 annual lease payments, the first of which is due immediately. In this case, the lessor will bear the maintenance costs. For simplicity, assume throughout this problem that all cash flows (including maintenance costs and resale values) can be discounted at the same rate as the lease-vs-buy cash flows.

(a) What is the maximum lease payment that GOODWEALTH is willing to pay?

GOODWEALTH has identified two potential lessors. Lessor A will have to spend $12,000 every year on maintenance costs. The (pre-tax) cost of debt for lessor A is 5%. Lessor B will have to spend only $3,000 every year on maintenance costs. The (pre-tax) cost of debt for lessor B is 15%. Assume that both lessor A and lessor B have the same tax rate as GOODWEALTH, and that both of them use the same depreciation method as GOODWEALTH.

(b) What is the minimum leasing payment that lessor A is willing to charge? What is the minimum leasing payment that lessor B is willing to charge?

(c) Can you explain the differences? Do you think your company will be willing to sign a lease contract with one of these potential lessors?