Lease Versus Purchase Starburst Brewery must replace some of its old equipment with new stainlesssteel equipment to avoid losing its license. The controller is unsure whether to purchase new equipment with borrowed money or to lease the equipment. If purchased, on January 1, - 2002, the equipment will cost $500,000 and have an estimated useful life of 20 years and no salvage value. Local Bank is willing to take a $500,000, 10-year, 12 percent note with interest-only payments to be made at the end of each year. Out-of-Town Leasing is willing to lease the equipment to Starburst for 9 years, with an option to purchase at the end of the lease. The following payment schedule would be required, providing Out-of-Town with a 12 percent return:

Starburst anticipates that it would exercise the purchase option because the option price is well below what the fair value of the equipment is expected to be at that date.

a. Compute the present value of the future cash outflows under both arrangements.

b. State what amounts would appear in Starburst’s 2002 income statement and balance sheet under both alternatives.

c. Which of the two financing alternatives should be selected?
Why? Explain what factors other than cash payments directly related to financing might be important to the decision.

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January 1, 2002 December 31, 2002 to 2009 December 31, 2010 $90,000 upon signing lease $90,000 per year $75,000 purchase option