Problem
The problem below allows you to demonstrate your understanding of these concepts.
Time to Fly Company needs to expand its facilities. To do so, the firm must acquire a machine costing $80,000. The machine can be leased or purchased. The firm is in the 25% tax bracket, and its after-tax cost of debt is 9%. The terms of the lease and purchase plans are as follows:
Lease. The leasing arrangement requires end-of-year payments of $19,800 over 5 years. All maintenance costs will be paid by the lessor; insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $24,000 at the termination of the lease.
Purchase. If the firm purchases the machine, its cost of $80,000 will be financed with a 5-year, 10% loan requiring equal end-of-year payments. The machine will be depreciated under MACRS using a 5-year recovery period (depreciation rates of 20%, 32%, 19%, 12%, and 12%, respectively). The firm will pay $2,000 per year for a service contract that covers all maintenance costs; insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5-year recovery period. (Hint: solve for the annual end-of-year loan payment first.)
A. Determine the after-tax cash outflows of Time to Fly Corporation under each alternative.
B. Find the present value of each after-tax cash outflow stream, using the after-tax cost of debt (9%) as your discount rate.
C. Which alternative-lease or purchase-would you recommend? Why?