Starburst Brewery Ltd. must replace some of its old copper equipment with new stainless steel equipment. The controller is unsure whether to lease the equipment or purchase it with borrowed money.
If purchased, the equipment will cost $800,000 and have an estimated useful life of 16 years and no residual value. The company's bank is willing to provide the $800,000 to Starburst, through a 10-year note bearing 8% annual interest payable at the end of each year. The principal amount would be due at the end of the 10 years.
A local rental company is willing to lease the equipment to Starburst for 12 years at an interest rate of 7%. At the end of each year, Starburst would be required to pay the leasing company $100,000. At the end of the lease period, title to the equipment would remain with the lessor.
Required:
a. Calculate the present value of the future cash flows under both arrangements.
b. State what amounts would appear in Starburst's statement of earnings and statement of financial position for the first year, under both alternatives. (Assume the new equipment is acquired on January 1.)
c. What factors, other than cash payments directly related to financing, might be important to the decision?
d. Which of the two financing alternatives would you recommend to the controller? Why?