The firm for which you work requires the use of a particular type of machine. To purchase the machine would cost $18,000 plus $500 to install. The machine falls in an asset class for which the allowable depreciation rate for tax purposes is 20 percent. The machine would be sold in five years and the firm estimates that it would be able to get $6,000 for it at that time. Instead of buying the machine, the firm also has the opportunity to lease it (the lessor would provide the machine and also cover the installation cost). The firm could sign a five year lease in which the first lease payment would be $3,000 and would be due immediately. A clause in the lease contract states that future yearly payments will increase at the rate of inflation (payments to be rounded to the next dollar). Inflation is expected to be 3% a year for the foreseeable future and the firm's tax rate is 40 percent. The company's cost of borrowing is 10 percent and its WACC is 15 percent.

(a) Should the firm lease or buy the machine? Show your calculations.

(b) Ignore your answer to (a) and assume that your answer to (a) is that there is a net advantage to leasing (based on the salvage value above) of $2,500 (which is not the correct number). Calculate the salvage value that would make you indifferent between buying and leasing.

Answer rating: 100% (QA)

a To determine whether the firm should lease or buy the machine we need to calculate the net present ... View the full answer