Reference no: EM13289350

Sadik Industries must install $1 million of new machinery in its Texas plant. It can obtain a bank loan for 100% of the required amount. Alternatively, a Texas investment banking firm that represents a group of investors believes it can arrange for a lease financing plan. Assume that the following facts apply:

(1) The equipment falls int he MACRS 3 -year class.
(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%, amortized in three equal installments at the end of each year.
(5) The tentative lease terms call for payments of $320,000 at the end of each year for 3 years. The lease is a guideline lease.
(6) Under the proposed lease terms, the lessee must pay for insurance, property taxes, and maintenance.
(7) Sadik must use the equipment if it is to continue in business, so it will almost certainly want to acquire the property at the end of the lease. If it does, then under the lease terms it can purchase the machinery at its fair market value at that time. The best estimate of this market value 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:

***Assuming the lease can be arranged, should the firm lease or borrow and buy the equipment, and considering the $200,000 estimated residual value, is it appropriate to discount it at the same rate as the other cash flows and are the other cash flows all equally risky?

In this situation, the firm plans to use the asset beyond the term of the lease. Thus, the residual value becomes a cost to leasing in Year 3. The firm will depreciate the equipment it purchases under the purchase option starting in Year 3, using the MACRS 3-year class schedule. Depreciation will begin in the year in which the equipment is purchased, which is Year 3.