The Olsen Company has decided to acquire a new truck. One alternative is to lease the truck on a 4-year contract for a lease payment of $9,748 per year, with payments to be made at the beginning of each year. The lease would include maintenance.

Alternatively, Olsen could purchase the truck with a bank loan for the truck’s after-tax cost of $27,000, amortized over a 4-year period at an interest rate of 10% per year, payments to be made at the end of each year. Under the borrow-to-purchase arrangement, Olsen would have to maintain the truck at a cost of $1,000 per year, payable at year-end. The truck has a salvage value of $3,600, which is the expected market value after 4 years, at which time Olsen plans to replace the truck regardless of whether the firm leases the truck or purchases it. (Note that the truck was fully depreciated at the time of purchase, so its book value is zero.) Olsen has a federal-plus-state tax rate of 25%.

a. What is Olsen’s PV cost of leasing?

b. What is Olsen’s PV cost of owning? Should the truck be leased or purchased?

c. The appropriate discount rate for use in Olsen’s analysis is the firm’s after-tax cost of debt. Why?

d. The salvage value is the least certain cash flow in the analysis. How might Olsen incorporate the higher risk of this cash flow into the analysis?