Alumco Industries must install $1 million of new computer equipment in its Ontario plant. It can obtain a bank loan for 100% of the required amount. Alternatively, Alumco believes that it can arrange for a lease financing plan. Assume that these facts apply:
(1) The computer equipment falls into asset Class 45 with a declining balance CCA rate of 45%.
(2) Estimated maintenance expenses are $50,000 per year.
(3) The firm's tax rate is 34%.
(4) If the money is borrowed, the bank loan will be at a rate of 14%.
(5) The tentative lease terms call for payments of $320,000 at the beginning of each year for
3 years.
(6) Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
(7) The best estimate of the market value at the end of 3 years is $200,000, but it could be much higher or lower under certain circumstances.
To assist management in making the proper lease-versus-buy decision, you are asked to answer the following questions:
a. Should the firm lease or borrow and buy the equipment? Explain.
b. Consider the $200,000 estimated residual value. Is it appropriate to discount it at the same rate as the other cash flows? What about the other cash flows-are they all equally risky?