Lifesavers Inc. is evaluating a project to manufacture a life vest that automatically inflates when submerged in water. Lifesavers has undergone a capital budgeting NPV analysis and has determined they should acquire some specialized equipment for their manufacturing process.
Jane has been hired as a Co-op student for the summer and has been asked to do a NAL analysis to determine whether it would make more sense to lease or purchase the asset.
Jane has examined the proposed lease and has determined the following:
(1) The equipment has a purchase price of $1,200,000 and has an eight-year useful life.
(2) The estimated salvage value is $250,000 in eight years.
(3) If Lifesavers acquires the equipment (accepts the project), they will generate after-tax cash flows of $120,000 per year.
(4) If Lifesavers purchases the equipment, it will cost the firm $5,000 today in training costs and these training costs will be expensed for income tax purposes. Under the terms of the lease, the lessor will be responsible for training costs.
(5) If they lease the equipment from CL Enterprises, the lease payments will be $125,000 per year for 8 years with the payments made at the beginning of the year.
(6) If the asset is purchased, Lifesavers will be responsible for maintenance costs of $15,000 per year; if leased, the lessee will be responsible for maintenance costs.
(7) The asset belongs in an asset class with a CCA rate of 25%.
(8) If the asset is leased, the cost to insure the asset would be more expensive, requiring the lessee to pay an additional $5000 per year (to be paid at the beginning of the year). These insurance costs will be expensed for income tax purposes.
(8) Lifesavers has a marginal tax rate of 40%. The before- tax cost of debt is 8%. The lease qualifies as a true tax lease for tax purposes.
Should Lifesavers buy or lease the equipment? Show all your work.
Compute the maximum amount of annual lease payment Lifesavers would be willing to make.