In a lease-or-buy decision, a four-year lease could be arranged with annual lease payments of $90,000, payable at the beginning of each year. The tax shield from lease payments is available at year-end. The firm’s tax rate is 40%. The machine costs $500,000 and has a four-year expected life, and no residual value is expected. If purchased, the asset would be financed through a term loan at 12%. The loan calls for equal payments to be made at the end of each year for four years. The machine would qualify for accelerated capital cost allowances written off on a straight-line basis over two years.
Calculate the cash flows for each financing alternative. Which alternative is the most economical?