4. Leasing

Thorenberg Inc. is considering the purchase of a machine from Hydraulic Engineering Company (HECO) to make hard pressed-metal sheets. The machine will cost $100,000 and would replace the currently used one. Savings are expected to be $60,000 per year, and the new machine is expected to last five years with proper maintenance. For tax purposes, the machine would be depreciated according to the straight-line method, and the tax rate is 36 percent. As an alternative to buying the machine, Thorenberg could lease it from Foster Leasing Corporation at a rate of $25,000 a year for five years, with payments made at the beginning of the year. All insurance, maintenance, and the cost of operating the machine would be the responsibility of Thorenberg. The interest rate at which Thorenberg can borrow on a medium- or long-term basis is 8 percent.

a. What are the cash flows from leasing relative to buying for Thorenberg Inc.? Should Thorenberg Inc. lease or buy the new machine?

b. What are the after-tax cash flows to Foster Leasing Corporation from buying and then leasing the machine to Thorenberg? Why are they the exact opposite of the cash flows to Thorenberg? (Assume that the two companies have the same effective corporate tax rate.)

c. If the cash flows to the lessee (Thorenberg) and the cash flows to the lessor (Foster) are exactly the opposite, why would the leasing nevertheless take place?