This is a is a lease vs buying that I have been struggling with. How do you work this?
Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm which represents a group of investors believes that it can arrange for a lease financing plan. Assume that these fact apply:
1. The equipment falls in the MACRS 3-year class.
2. Estimate maintenance expenses are $50,000 per year.
3. The firm's tax rate is 34%.
4. If the money is borrowed, the bank loan will be at a rate of 14%, amortized in 3 equal installments at the end of each year.
5. The tentative lease calls for payments of $320,000 at the end of each year for 3 years. The lease is a guideline lease.
6. Under the proposed leased terms, the lessee must pay for insurance, property tax, and maintenance.
7. Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at that time. The best estimate of this market value is $200,000, but it could be much higher or lower under certain circumstances.
To assist management in making the proper-lease-versus-buy decision, you are asked to answer the following questions:
a. Assuming the lease can be arranged, should the firm lease or borrow and buy the equipment? Explain.
b. Consider the $200,000 estimated residual value. It is appropriate to discount it at the same rate as the other cash flows? What about other cash flows- are they all equally risky?
This posting gives a detailed solution to the student's Lease Vs. Buy question.