Alamo Annuities Inc. has decided to acquire a new quotation system for its San Antonio office. The system receives current market prices and other information from several on-line data services, then either displays the information on a screen or stores it for later retrieval by the firm's brokers. The system also permits customers to call up current quotes on terminals in the lobby.
The equipment costs $2,000,000, and, if it were purchased, Alamo could obtain a term loan for five years for the full purchase price at a 12 percent interest rate. The loan would be interest only each year and the full principal payment at the end of year five. The equipment has a seven-year useful life and it can be depreciated on a straight-line basis. If the system were purchased, a 5-year maintenance contract could be obtained at a cost of $40,000 per year, payable at the beginning of each year. The equipment would be sold after 5 years, and the best estimate of its residual value at that time is $350,000. However, since real-time display system technology is changing rapidly, the actual residual value is uncertain.
As an alternative to the borrow-and-buy plan, the equipment manufacturer informed Alamo that Houston Leasing would be willing to write a 5-year guideline lease on the equipment, including maintenance, for payments of $500,000 at the beginning of each year. Lewis's marginal federal-plus-state tax rate is 33 percent. You have been asked to analyze the lease-versus-purchase decision.
Compute the NAL for this transaction. Should Alamo lease or borrow and buy?
Comment on the effects that a different loan rate and residual value would have on your answer above.