Trasky Company is trying to decide whether it should purchase or lease a new auto- mated machine to be used in the production of a new product. If purchased, the new machine would cost $100,000 and would be used for 10 years. The salvage value at the end of 10 years is estimated at $20,000. The machine would be depreci- ated using MACRS over a seven-year period. The annual maintenance and operating costs would be $20,000. Annual revenues are estimated at $55,000.
If the machine is leased, the company would need to pay annual lease payments of $20,700. The first lease payment and a deposit of $5,000 are due immediately.
The last lease payment is paid at the beginning of Year 10. The deposit is refundable at the end of the tenth year. In addition, under a normal contract, the company must pay for all maintenance and operating costs, although the leasing company does offer a service contract that will provide annual maintenance (on leased machines only). The contract must be paid up front and costs $30,000. Trasky estimates that the contract will reduce its annual maintenance and operating costs by $10,000.
Trasky's cost of capital is 14 percent. The tax rate is 40 percent.
Required
1. Prepare schedules showing the after-tax cash flows for each alternative. (Prepare schedules for the lease alternative with and without the service contract; assume that the service contract is amortized on a straight-line basis for 10 years.) Include all revenues and costs associated with each alternative.
2. Compute the NPV for each alternative assuming that Trasky does not purchase the service contract. Should the machine be purchased or leased? For this analysis, was it necessary to include all of the costs and revenues for each alternative? Explain.
3. Compute the NPV for the lease alternative assuming that the service contract is purchased. Does this change your decision about leasing? What revenues and costs could be excluded without affecting the conclusion?