Eastern Trucking Company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 40 percent tax bracket, and its after-tax cost of debt is 5.4 percent. The terms of the lease and purchase plans are as follows:
Lease. The leasing arrangement requires beginning-of-year payments of $16,900 over five years. The lessor will pay all maintenance costs; the lessee will pay insurance and other costs. The lessee will exercise its option to purchase the asset for $20,000 paid along with the final lease payment. Purchase.
If the firm purchases the machine, its cost of $80,000 will be financed with a five-year, 9 percent loan requiring equal end-of-year payments of $20,567. The machine will be depreciated under MACRS using a fi ve-year recovery period.
(See Table for applicable MACRS percentages.) The firm will pay $2,000 per year for a service contract that covers all maintenance costs; the firm will pay insurance and other costs.
The firm plans to keep the equipment and use it beyond its five-year recovery period.
a. Determine the after-tax cash outflows of Eastern Trucking under each alternative.
b. Find the present value of the after-tax cash outflows for each alternative using the after-tax cost of debt.
c. Which alternative, lease or purchase, would you recommend? Why?
