Discount Cash Flow Analysis

The Optimo Company in operating 10 sugar plantations used large amounts of heavy equipment. Optimo has been approached by a leasing company which has offered to lease Optimo many kinds of equipment. As an example, the leasing company has offered the following terms on a $21,500 truck.

Years Lease Payment

1 $4,000

2 4,000

3 3,600

4 3,600

5 3,600

6 3,600

7 3,600

Optimo estimates that operating savings from using this truck will be $12,000 per year.

If Optimo buys the truck it will be able to write it off to a residual of $500 over a 7 year period.

Tax rate for this company is 30%

Show costs and earnings in a form which would be used if Optimo were to use the discounted cash flow method of analyzing the lease vs. purchase decisions. What should their choice belease or purchase?

Note to Optimo:

We begin with the assumption that the truck is needed. We can lease it, but we want to know whether it would be profitable to go one-step furtherthat is, purchase it. The question to be answered is this: Will the differential investment, purchase vs. lease, yield a higher rate of return than the firms cost of capital? If it is higher, we purchase the truck; if not, we will lease it.

How would the decision change if the savings from using the truck were $20,000 per year? Reanalyze the problem and comment on the results and the affects of the increased earnings on the analysis.