APPENDIX 16B Lease versus purchase decision (LO16-4)

Preston Corporation is considering whether to borrow funds and purchase an asset or to lease the asset under an operating lease arrangement. If the company purchases the asset, the cost will be $110,000. It can borrow funds for four years at 12 percent interest. The firm will use the three-year MACRS depreciation category (with the associated four-year write-off). Assume a tax rate of 35 percent.

The other alternative is to sign two operating leases, one with payments of $28,600 for the first two years, and the other with payments of $50,600 for the last two years. In your analysis, round all values to the nearest dollar.

a. Compute the aftertax cost of the leases for the four years.

b. Compute the annual payment for the loan (round to the nearest dollar).

c. Compute the amortization schedule for the loan. (Disregard a small difference from a zero balance at the end of the loan due to rounding.)

d. Determine the depreciation schedule (see Table 12-9).

e. Compute the aftertax cost of the borrow-purchase alternative.

f. Compute the present value of the aftertax cost of the two alternatives. Use a discount rate of 8 percent.

g. Which alternative should be selected, based on minimizing the present value of aftertax costs?