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Lease Versus Purchase Decision

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Beryl's Iced Tea currently rents a bottling machine for $50,000 per year, including all maintenance expenses. It is considering purchasing a machine instead, and is comparing two options:

a. Purchase the machine it is currently renting for $150,000. This machine will require $20,000 per year in ongoing maintenance expense.

b. Purchase a new, more advanced machine for $250,000. This machine will require $15,000 per year in ongoing maintenance expenses and will lower bottling costs by $10,000 per year. Also, $35,000 will be spent upfront in training the new operators of the machine.

Suppose the appropriate discount rate is 8% per year and the machine is purchased today. Maintenance and bottling costs are paid at the end of each year, as is the rental of the machine. assume also that the machine will be depreciated via the straight line method over seven years and that they have a 10 year life with a negligible salvage value. The marginal corporate tax rate is 35%. Should Beryl's Iced Tea continue to rent, purchase its current machine, or purchase the advanced machine?

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This solution illustrates how to perform a lease versus purchase analysis.

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Summarize different capital budgeting concepts by answering the following questions:

1) What risks and uncertainties should be considered while making a lease vs. buy decision? How do these risks and uncertainties impact capital budgeting?

2) What is the advantage of computing the present value of outflows in making lease vs. buy decisions?

3) In what circumstances is a capital lease a better alternative to an operating lease? Under what circumstances is a capital lease a better alternative than buying an asset?

4) How do qualitative factors like the condition of an asset impact a final lease or buy decision?

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