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Decision Making: Lease vs. Purchase

Edison Electronics is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If it purchases the asset, the cost will be $8,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent.

Lease versus purchase Decision

The other alternative is to sign two operating leases, one with payments of $2,100 for the first two years, and the other with payments of $3,700 for the last two years. In your analysis, round all values to the nearest dollar.

1. Compute the after-tax cost of the leases for the four years.
2. Compute the annual payment for the loan (round to the nearest dollar).
3. Compute the amortization schedule for the loan. (Disregard a small difference from a zero balance at the end of the loan due to rounding.)
4. Determine the depreciation schedule (see Table 12-9 in Chapter 12).
5. Compute the after-tax cost of the borrow-purchase alternative
6. Compute the present value of the after-tax cost of the two alternatives. Use a discount rate of 8 percent.
7. Which alternative should be selected, based on minimizing the present value of after-tax costs?
Table 12-9
Depreciation Year 3-Year MACRS 5-Year MACRS 7-Year MACRS 10-Year MACRS 15-Year MACRS 20-Year MACRS
1 .333 .200 .143 .100 .050 .038
2 .445 .320 .245 .180 .095 .072
3 .148 .192 .175 .144 .086 .06
4 .074 .115 .125 .115 .077 .062
5 .115 .089 .092 .069 .057
6 .058 .089 .074 .062 .053
7 .089 .066 .059 .045
8 .045 .066 .059 .045
9 .065 .059 .045
10 .065 .059 .045
11 .033 .059 .045
12 .059 .045
13 .059 .045
14 .059 .045
15 .059 .045
16 .030 .045
17 .045
18 .045
19 .045
20 .045
21 .017
1.000 1.000 1.000 1.000 1.000 1.000

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Solution Summary

The solution explains how to calculate the cash flows under lease and purchase options and to make the correct selection.

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