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lease the machine or buy it with bank financing?

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Wolfson Corporation has decided to purchase a new machine that costs \$3 million. The
machine will be worthless after three years. Only straight-line method is allowed by the IRS
for this type of machine.Wolfson is in the 35-percent tax bracket.
The Sur Bank has offered Wolfson a three-year loan for \$3 million.The repayment schedule
is three yearly principal repayments of \$1 million and an interest charge of 12 percent on
the outstanding balance of the loan at the beginning of each year. Twelve percent is the
marketwide rate of interest. Both principal repayments and interest are due at the end of
each year.
Cal Leasing Corporation offers to lease the same machine to Wolfson. Lease payments of
\$1.2 million per year are due at the end of each of the three years of the lease.
a. Should Wolfson lease the machine or buy it with bank financing?
b. What is the annual lease payment that will make Wolfson indifferent to whether it leases
the machine or purchases it?

Solution Preview

year 1: \$1 million principal plus 12% interest X \$3 million = \$1,360,000
less tax benefit: \$1 million depreciation + \$360,000 interest expense X 35% tax bracket = \$476,000 tax reduction
total cost: \$884,000
year 2: \$1 million principal plus 12% interest X \$2 million = \$1,240,000
less tax benefit: \$1 million depreciation + \$240,000 interest expense X 35% tax bracket = \$434,000 tax reduction
total cost: \$806,000
year 3: \$1 ...

Solution Summary

financial comparison for a company to lease equipment or buy it with mathematical solution.

\$2.49