Question 12.1: The economic life of the equipment is three years. You have ...
The Assumptions
1. No tax considerations.
2. No uncertainty regarding cash flows.
3. The investment has no salvage value.
The Problem
The economic life of the equipment is three years. You have already decided to proceed with the project, but the problem is whether to buy the machine at a cost of $90,000 or lease it from the manufacturer at an annual lease fee of $36,829 for three years. The lease is “net, net”, meaning that you provide all the maintenance and insurance.
The Analysis
A call to the local banker reveals that the bank is willing to lend your firm the $90,000 at an interest rate of 10 percent. This, the bank lending officer informs you, will require annual payments of $36,190. The bank credit officer did the following calculations to obtain the annual payments. Let R be the annual payment; then,
R × B(3, 0.10) = $90,000 or R=\frac{\$90,000}{2.4869}= \$36,190.
The Decision
Since buy-borrow is cheaper than lease by $639 per year for the three years, you arrange for the loan and purchase the equipment. The firm would rather pay $36,190 to the bank than $36,829 to the lessor. It can be shown that the lease has an implicit cost of 11 percent.
Given these facts, we see that buy-borrow is preferred to lease if it is already decided that we need the equipment. Thus, our decision at the second node of the decision tree depicted in Figure 12.2 is to buy-borrow. Now consider the first decision — the acquisition decision.
