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Asset investment decisions and capital rationing

Question 2

Lease vs buy
A company has already decided to acquire a new machine in order to make
cost savings on production. It needs to decide whether to lease or buy the
machine.

The machine would cost $500,000 and the company would be able to claim tax-
allowable depreciation on a 25% reducing balance basis. The machine would
be worthless at the end of the project.

Alternatively, the company could enter into a four year lease for the asset with
annual payments of $160,000 starting immediately.
Tax is payable at 30%, one year in arrears.

Calculate whether the company should lease or buy the asset.

Purchase costs:

0 1 2 3 4 5
asset purchase (500,000)
tax savings on tax-
allowable depreciation 37,500 28,125 21,094 63,281

discount factor 10% 1 0.909 0.826 0.751 0.683 0.621

PV (500,000) 0 30,975 21,122 14,407 39,298
PV of costs (394,198)

Lease costs:
0 1 2 3 4 5

lease payments (160,000) (160,000) (160,000) (160,000)
tax savings on lease
payments 48,000 48,000 48,000 48,000
net cash flow (160,000) (160,000) (112,000) (112,000) 48,000 48,000

discount factor 10% 1 0.909 0.826 0.751 0.683 0.621
PV (160,000) (145,440) (92,512) (84,112) 32,784 29,808
PV of costs (419,472)

The purchase option is cheaper by $25,274

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