Morris Company, a small manufacturing firm, wants to acquire a new machine that costs $30,000. Arrangements can be made to lease or purchase the machine. The firm is in the 40% tax bracket. The firm has gathered the following information about the two alternatives:

Lease Morris would obtain a 5-year lease requiring annual end-of-year lease payments of $10,000. The lessor would pay all maintenance costs; insurance and other costs would be borne by the lessee. Morris would be given the right to exercise its option to purchase the machine for $3,000 at the end of the lease term.

Purchase Morris can finance the purchase of the machine with an 8.5%, 5-year loan requiring annual end-of-year installment payments. The machine would be depreciated under MACRS using a 5-year recovery period. The exact depreciation rates over the next six periods would be 20%, 32%, 19%, 12%, 12%, and 5%, respectively. Morris would pay $1,200 per year for a service contract that covers all maintenance costs. The firm plans to keep the machine and use it beyond its 5-year recovery period.

TO DO

Create a spreadsheet similar to Tables 17.1, 17.2, and 17.3 to answer the following:

  a. Calculate the after-tax cash outflow from the lease for Morris Company.

  b. Calculate the annual loan payment.

  c. Determine the interest and principal components of the loan payments.

  d. Calculate the after-tax cash outflows associated with the purchasing option.

  e. Calculate and compare the present values of the cash outflows associated with both the leasing and purchasing options.

  f. Which alternative is preferable? Explain.