Lease-or-Buy Decision
The Dallas Electronics Company is considering replacing an old, 1,000-pound-capacity industrial forklift truck. The truck has been used primarily to move goods from production machines into storage. The company is working nearly at capacity and is operating on a two-shift basis six days per week. Dallas management is considering owning or leasing the new truck. The plant engineer has compiled the following data for management.
- The initial cost of a gas-powered truck is $20,000. The new truck would use about 8 gallons of gasoline (in a single shift of 8 hours per day) at a cost of $3.35 per gallon. If the truck is operated 16 hours per day, its expected life will be four years, and an engine overhaul at a cost of $1,500 will be required at the end of two years.
- The Austin Industrial Truck Company has been servicing the old forklift truck, and Dallas would buy the new truck through Austin, which offers a service agreement to users of its trucks. The agreement costs $120 per month and provides for a monthly visit by an experienced service representative to lubricate and tune the truck. Insurance and property taxes for the truck are $650 per year.
- The truck is classified as five-year property under MACRS and could be depreciated accordingly. Dallas can take advantage of the Section 179 tax deduction. In that case, the full purchase amount of $20,000 can be deducted from its gross income. Dallas is in the 40% marginal tax bracket; the estimated resale value of the truck at the end of four years will be 15% of the original cost.
- Austin also has offered to lease a truck to Dallas. Austin will maintain the equipment and will guarantee to keep the truck in serviceable condition at all times. In the event of a major breakdown, Austin will provide a replacement truck at its expense. The cost of the operating lease plan is $850 per month. The contract term is three years at a minimum, with the option to cancel on 30 days’ notice thereafter.
- On the basis of recent experience, the company expects that funds committed to new investments should earn at least a 12% rate of return after taxes.
(a) Determine the cost of owning the truck.
(b) Determine the cost of leasing the truck.
Discussion: We may calculate the fuel costs for two-shift operation as
(8 gallons/shift)(2 shifts/day)($3.35/gallon) = $53.60 per day
The truck will operate 300 days per year, so the annual fuel cost will be $16,080. However, both alternatives require the company to supply its own fuel, so the fuel cost is not relevant to our decision making. Revenue streams would be the same as fuel costs. Therefore, we may drop these common items from our calculations.
