Eastern Trucking Company needs to expand its facilities. In order to do so, the firm must acquire a machine costing $800,000. The machine can be leased or purchased.
The firm is in the 40% tax bracket, and it's after tax cost of debt is 5.4%. The terms of the lease and purchase plans are as follow:
Lease: The leasing arrangement requires beginning of year payments of $16,900 over five years. The lessee will exercise its option to purchase the asset for $20,000, to be paid along with the final lease payment.Purchase: if the firm purchases the machine, its cost of $80,000 will be financed with a five year, 9% loan (pre-tax) requiring equal end of year payments of $20,567.
The machine will be depreciated on a straight line basis for five years. The firm plans to keep the equipment and use it beyond its five year recovery period.
a. Determine the after tax cash outflows of Eastern Trucking under each alternative.
b. Find the present value of the after tax cash outflows for each alternative using the after tax cost of debt.
c. Which alternative lease or purchase would you recommend? Why