Fresh Farming Company is negotiating a lease for five new tractors with Leasing International. The terms of the lease offered by Leasing International call for a total payment of $205,000 at the beginning of each year of a 5-year lease.
As an alternative to leasing, Fresh Framing can borrow from a local bank and buy the tractors. Fresh Farming has received its best offer for buying the tractors from Trucks, Inc. for a total price of $1 million. The $1 million would be borrowed on a simple interest term loan at a 10 percent interest rate for 5 years.
The tractors fall into the MACRS 5-year class and have a total expected residual value of $100,000. The depreciation rates are 20.00%, 32.00%, 19.20%, 11.52%, 11.52% and 5.76%, for Years 1 to 6, respectively. Maintenance costs would be included in the lease payments. If the tractors were owned, a maintenance contract would be purchased at the beginning of each year for a total of $10,000 per year.
In any case, Fresh Farming plans to buy a new fleet of tractors at the end of the fifth year. Leasing International has a 40% federal-plus-state marginal tax rate, while Fresh Farming has a total tax rate of 20%.
a What would be Fresh Farming’s present value of owning the tractors?
b What would be Fresh Farming’s present value of leasing the tractors?
c Should Fresh Farming lease the tractors? Why or why not?
d Assume that the lessor’s alternative to leasing (i.e. making an investment with similar risk to leasing) is to invest in a 5-year certificate of deposit that pays 9 percent before taxes. Should the lessor write the lease? Why or why not?