Swenson Company plans to acquire new chemical processing equipment on January 1, the beginning of the company’s fiscal year. The equipment costs $2 million. Swenson can either borrow $2 million from a bank or lease the equipment. Both the bank and the leasing company believe that a 10% interest rate is appropriate, given Swenson’s credit history. A lease would be accounted for as a capital lease. The equipment is expected to have a useful life of four years, which would be the same as the lease period. The equipment is expected to have zero residual value. Swenson normally uses the straight-line method to depreciate its equipment. The lease alternative would require year-end payments of $635,000 each year. If money is borrowed from a bank, four year-end payments would be required. Each payment would include one-fourth of the principal amount borrowed plus all of the interest expense that had been incurred on the unpaid balance during the year.
Required
As the Chemical Division manager, you have been asked to evaluate the alternatives and to recommend the best choice for acquiring the equipment. Determine the comparative effects of purchasing versus leasing the equipment on Swenson’s income statement, balance sheet, and statement of cash flows over the four-year period. Evaluate the alternatives and make a recommendation to top management.