You own a factory and are evaluating two options to replace your machines. Either you can take out a five-year lease on the replacement machines for $6000 per annum per machine, or you can purchase the machines outright for $30000, in which case the machines will last eight years. You must return the machines to the leasing company at the end of the lease. The leasing company is responsible for all maintenance costs, but if you purchase the machines, you will buy a maintenance contract that will cost $1000 per annum for the life of each machine. Because the machines are custom-made for your factory, they are hard to re-sell if you purchase the machines.
Your technology is very cost efficient. However, it is not exactly “green”. According to the government’s long-term plan for the environment, a new law to reduce manufacturing waste might become effective starting in year 6 with a 50% possibility. The law will make your technology costlier to implement; without the law, each machine generates cash flows of $20000 per annum before the leasing and maintenance costs. Under the law, however, each machine will generate cash flows of only $8000 per annum before the leasing and maintenance costs. Assume the cost of capital is fixed at 12%. All cash flows are generated at the end of each year.
a) Calculate the NPV per machine of leasing the machines.
b) Calculate the NPV per machine of purchasing the machines.
Comparing the two options based on the NPVs is not fair because the leasing option has a shorter life span than the purchasing option. To truly compare the two options, we must consider what will happen once the leasing ends. Let’s assume that if you are leasing a machine, you have the opportunity to buy the used machine for $10000 at the end of year 5. The used machine will have maintenance costs of $5000 per annum and will last three more years.
c) Suppose it is now year 5 and the government has decided to abandon the long-term environmental plan. If you have been leasing the machines for the past 5 years, will you buy the used machines for $10000 per machine? What is the year-5 payoff of the option to buy the used machine?
d) Suppose it is now year 5 and the government has passed the new environmental law. If you have been leasing the machines for the past 5 years, will you buy the used machines for $10000 per machine? What is the year-5 payoff of the option to buy the used machine?
e) Recalculate the NPV per machine of leasing the machines accounting for your decisions in part (c) and (d).
f) Which option should you take?