Question: A government agency that pays no taxes is evaluating whether to lease or to purchase an asset. In the latter case, financing could be obtained through a bank loan at an interest rate of 9 percent. Lease payments would be $ 1 0,000 per year payable at the beginning of each year, and loan repayments would amount to $ 12,000 per year payable at the end of each year, both to be incurred over the next 5 years. The anticipated salvage value of the asset is $2,000. Given the uncertainty inherent in this estimate, the discount rate applicable to the residual value is 13 percent.
(a) Which alternative would you recommend?
(b) What would the expected salvage value have to be before you would reverse your decision under (a) above?