Your employer, Barnaby Well Company, is considering the acquisition of a new drill truck and your boss has asked you to evaluate the decision that she has made to buy the truck. The truck has a purchase price of $60,000 and a useful life of 4 years and a zero salvage value. Barnaby can borrow to buy the truck for $60,000 or lease the truck for $15,000 for 4 years, paid at the beginning of each year.
If debt is used to buy the truck, Barnaby can borrow at 8% annual interest, with payments at the end of each year. The marginal tax rate for the firm is 40%. The asset is classified as a 3-year cost recovery asset for depreciation purposes. According to the current tax laws, Barnaby is allowed to use MACRS depreciation with 30% rate for year one, 45% for year two, 20% for year three and 5% for year four. There will be no salvage value at the end of the fourth year.
Questions:
1. What is the annual cost, before any tax considerations, of the lease option? Are there any tax considerations and if so, what is the after tax annual cost of the lease agreement? Explain your answer.
2. What is the total cost of leasing the truck today?
3. What are the annual cash flows if the truck is purchased with debt financing?
4. What is the cost of purchasing the truck with debt financing today?
5. Make a recommendation to your boss as to whether the company should buy or lease the truck. Justify your recommendations.