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Lease alternative versus borrow and purchase alternative

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.

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.

a. Compute the aftertax cost of the leases for the four years.
b. Compute the annual payment for the loan (round to the nearest dollar).
c. Compute the amortization schedule for the loan. (Disregard a small difference from a zero balance at the end of the loan due to rounding.)
d. Determine the depreciation schedule.
e. Compute the aftertax cost of the borrow-purchase alternative.
f. Compute the present value of the aftertax cost of the two alternatives. Use a discount rate of 8 percent.
g. Which alternative should be selected, based on minimizing the present value of aftertax costs?

Solution Preview

Please see the attached file for complete solution. Thanks

Part A
Year Lease Payments tax rebate on lease rentals post tax cost
0
1 2100 735 1365
2 2100 735 1365
3 3700 1295 2405
4 3700 1295 2405

Part B
Annual payments of the loan = Loan amount / present value of interest factors annuity
Present ...

Solution Summary

The problem walks you through how to make a decision between whether to borrow and buy an asset or to take the asset on operating lease. First, we calculate the cash flows associated with the two alternatives and then calculate the PV of the cost so that we can compare the two alternatives. The concepts covered in the problem include amortization schedule, depreciation schedule, the tax treatment of lease and interest payment under buy option, calculation of PV of cost, etc.

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